What Does the CPI Measure? The Case of Housing and Cars

Ask anyone if there is an inflation problem and they will likely say, "Well Canada's CPI is up 4.8% in December 2021 and that's the highest since 1991." Editorialists will say such things as "the cost of living is out of control" and support their argument by pointing to the rate of increase of the Consumer Price Index.

When I was downloading some CPI data from Statistics Canada I noticed this footnote:

The Consumer Price Index (CPI) is not a cost-of-living index. The objective behind a cost-of-living index is to measure changes in expenditures necessary for consumers to maintain a constant standard of living. The idea is that consumers would normally switch between products as the price relationship of goods changes. If, for example, consumers get the same satisfaction from drinking tea as they do from coffee, then it is possible to substitute tea for coffee if the price of tea falls relative to the price of coffee. The cheaper of the interchangeable products may be chosen. We could compute a cost-of-living index for an individual if we had complete information about that person's taste and spending habits. To do this for a large number of people, let alone the total population of Canada, is impossible. For this reason, regularly published price indexes are based on the fixed-basket concept rather than the cost-of-living concept.

So, it's not a cost of living index. I thought that I'd better go to the Bank of Canada website to see what the Bank says because, after all, they target keeping CPI inflation at 2%. So this is from the BoC's website: 

The CPI is a simple and familiar measure of price changes, or inflation. Employers use it to make cost-of-living adjustments in wages and salaries. Governments use it to adjust income taxes and social benefits such as the Canada Pension Plan and Old Age Security.

OK, so now I'm confused. It's not a cost of living index, but the Bank of Canada says employers and governments use it as a cost of living index.

I know some of the history. When inflation was out of control in the 1970s, there was lots of talk about a wage-price spiral. Prices were rising fast, so workers often went on strike and bargained for higher wages. When higher wages were granted to cover the rising cost of living, producers of goods and services raised their prices and a wage price spiral ensued. During a period of high inflation, employers and governments come under pressure to increase wages and government benefits. This was especially true for programs and wages that were indexed to the CPI. Some economists then argued that the CPI was overstating inflation and the rise in the cost of living. In the US, the Boskin Commission recommended a variety of changes to way inflation was measured to reduce what was viewed as an "upward bias" in the CPI. One of the changes was to introduce hedonic pricing for some items in the CPI to try to capture the effects of quality change. Anyway, the recommendations were adopted by many countries, including Canada, and this had the effect of dampening inflation as measured by the CPI.

So today, even with these changes made to the CPI, Statistics Canada says it is not a cost of living index, but it is widely used as a cost of living index to adjust some wages as well as many public and private pension payments.

These days, the complaint most often heard, at least form the general public, is that the CPI understates inflation and the rising cost of living that they are experiencing. Most of these complaints come from looking at the way housing and automobiles are treated in the CPI. We hear from the real estate industry that house prices were up 26.6% from a year earlier in December 2021, but the CPI measure of housing (what they call "owned accommodation) is only up 5.8%. What gives? We hear from the auto industry that because of a global shortage of microchips, new cars can't be completed and their prices are rising sharply. We hear from the used car industry that the shortage of new cars and trucks has pushed consumers into buying used vehicles and their prices are soaring by as much as 30-40%. But Canada's CPI for motor vehicle purchase was up just 7.2% in December, while the US CPI for new and used vehicles was up 21%. What gives?   

Housing Prices in the CPI

Statistics Canada has heard these complaints before. In 2017, during an earlier spike in house prices when the CPI was not tracking what people were seeing happening to house prices, StatCan published a note on the measurement of housing prices in the CPI. Here are some excerpts from the note:

There are many approaches to processing owned accommodation: payment, net acquisition, rental equivalence, user cost, and exclusion altogether. Depending on the main purpose of its CPI (indexation, deflation of expenditures or incomes, monitoring monetary policies), each statistical agency adopts a version of one of these approaches.....

The “net acquisition” approach consists of treating owner-occupied dwellings like all other durable goods in the CPI, which means attributing all dwelling purchase costs to the acquisition period, even if the useful life of the dwelling spans well beyond this period. For this option, net dwelling purchases in the reference year would be used as the expenditure weight for owned accommodation. Since it provides the possibility of instantly showing the impact of dwelling price changes on the CPI, the “net acquisition” approach has interesting characteristics for measuring price inflation and monitoring monetary policy. However, since it does not take into account the stream of services generated by the owned accommodation across time, it is less favoured for a CPI that is used primarily for indexation...

... there is a general consensus that the acquisition approach is the most suitable for handling owned accommodation, when the primary use is tracking inflation in the housing market, since this approach makes it possible to automatically show the impact of changes in dwelling prices... 

On the other hand, an owned accommodation index like the one adopted by the Canadian CPI, based on the user cost approach does not seek to measure changes in dwelling prices. Its purpose is to determine changes in the cost of using a stock of dwellings. This makes it sensitive to past movements in housing prices, as well as imputed costs such as depreciation. Those wishing to use the CPI as an indicator of inflation in the housing market must be aware of the inherent limitations of such an approach, and should not expect it to produce an index that automatically tracks movements in dwelling prices. 

Now, I'm getting more confused. StatCan says the CPI is not a cost of living index. But when it comes to choosing a method of measuring housing prices, they choose a method which they judge is more appropriate for (cost-of-living) indexation. They reject a method which is "most suitable... for tracking inflation in the housing market" and "monitoring monetary policy".

Well, what difference does it make? Suppose, that we equally-weighted Statistics Canada's New House Price Index (up 11.7%) and the Teranet House Price Index for existing homes (up 15.5%)  and used the result (up 13.2%) in the CPI instead of StatCan's user cost approach to measuring owned accommodation prices (up 5.8%). Owned accommodation has a weight of 19.2% in Canada's CPI, so using StatCan's method, it contributes (.192 x 5.8%) or 1.1 percentage points to the December inflation rate of 4.8%. If we used the equally weighted increase in new and existing house prices (13.2%), the contribution of owned accommodation would be (.192 x 13.2%) or 2.6 percentage points to the CPI inflation rate.  

Motor Vehicles in the CPI

Prior to the pandemic, most people, including most economists probably thought that the price of motor vehicles was treated the same in measuring both the Canadian and US CPI. But they are not. This became evident when US inflation started spiking in the spring of 2021 and one of the leading causes was the sharp rise in prices of used vehicles. When that happened, I for one, did take the trouble to look at Canada's CPI breakdown to see what was happening to used vehicle prices in Canada. But there was nothing there. A phone call and an email to StatCan returned the information that, "No, Canada's CPI does not include used cars, only new cars." 

So then one has to look for industry information to see what is happening with used vehicle prices. The US has the Manheim index which provides a clear picture that used car prices have surged in the US and most of this surge is being picked up in the US CPI. Manheim does not have an index for Canada, but some time spent searching the web shows that CarGurus has an estimate that in Canada, used vehicle prices are up 35-40%. Well, how important could that be, you might ask?

Google is a wonderful tool for getting answers. I'm not a statistician and the following comments might be questioned by an expert, but here goes.

First, how important are used vehicle sales? Well, in the US new vehicle sales in 2021 were about 15 million units. Used vehicle sales were 40.1 million. Almost three times as many used vehicles are sold to consumers compared to new vehicles. 

The average price of new vehicles in the US rose to a record US$47,000 in December 2021 according to Kelly Blue Book and increase of 15.2%. The US CPI measured US new vehicle prices to be up 11.8% in December. The difference is probably mostly accounted for by the "hedonic quality adjustment" done for the CPI. But if you are a consumer who bought a car, the average price was up 15.2% as the Blue Book says.

The average price of used vehicles in the US rose to a record US$28,200 according to Cox Automotive in December 2021, up by a stunning 46.6% from year earlier. The US CPI measured used vehicle prices to be up 37.3% in December. 

Based on the US CPI measures, new and used vehicles contributed 1.5 percentage points to US CPI inflation of 7.1% in December. If the industry measures of price increases were used the contribution would have been 1.9% and total inflation would have been 7.5%.

In Canada, new vehicle sales were 1.66 million in 2021. There is no industry data that I could find on Canadian used car sales, but since the auto markets in Canada and the US are very similar, one could estimate that used vehicle sales in Canada are probably in the 4 to 4.5 million range. The best guide the used vehicle prices is the CarGurus price index which recently showed a 34% increase over a year ago, lower than the US industry estimate, but quite close to the US CPI estimate.

Based on Canada's CPI measures, the increase in new vehicle prices added 0.45 percentage points to Canada's CPI inflation of 4.8% in December 2021. Of course, used vehicle prices contributed zero percentage points because they are not included. So, even though the auto markets in Canada and the US experienced very similar conditions in 2021, vehicle prices contributed just .45% to Canada's inflation rate compared with 1.5% in the US. Thus, it would seem that Canada's CPI is probably understated by at least 1 percentage point due to the exclusion of used car prices. 

If used vehicle prices had been included, using the CarGurus estimate, and if Blue Book prices had been used for new cars (rather than the hedonically quality-adjusted estimates used by Statistics Canada) then the contribution of new and used vehicle prices to Canada's CPI could have been as much as 1.7 percentage points (instead of 0.45 pct pts).

Concluding Comments

A lot of people are experiencing inflation differently from the official statistics. In the 1970s, the argument was that the CPI was overstating inflation. Today, it feels like the CPI is significantly understating inflation. Statistics Canada admits that the method it uses to measure owned accommodation prices is not the best measure for gauging inflation and for monetary policy purposes. The Bank of Canada does not acknowledge this. The exclusion of used vehicle prices from calculation of Canada's CPI is clearly understating inflation as it is experienced by consumers. If we used easily understandable alternate measures of prices for houses, CPI inflation would be about 1.5 percentage points higher. If we included used vehicles and used industry estimates for vehicle price increases would be as much as 1.7 percentage points higher. Just adjusting the two components, which make up about 25% of the CPI, would boost our estimate of actual inflation being experienced on average by actual people by something between 2.5 and 3.2 percentage points. That would put December's CPI inflation not at 4.8%, but somewhere between 7.3% and 8.0%. That is probably closer to how consumers are experiencing inflation today than the official estimate.  

Despite a warning from Statistics Canada that the CPI is not a cost of living index, it is widely used for cost of living adjustments. The Bank of Canada continues to express optimism that once supply chain pressures ease, inflation should drift back down toward the 2% target, but consumers can't be blamed for being skeptical. Despite commentators suggesting that Canada's inflation is not as bad as in the US, it probably is as bad or worse.       

 

      

 

Update on Economic Projections from the Bank of Canada

This is a follow-up on my post, Canada Post Covid19, from March 31. I concluded that post with the following:

Bank of Canada Governor Poloz said that the lowered private sector forecasts he was seeing were little more than arithmetic and promised to unveil new projections on April 15th from the Bank of Canada's forecasting team, which he described as "the best there is". He suggested that more than just doing arithmetic, the Bank of Canada's forecasters would take account of confidence effects and how behavior might change in the post-Covid19 world. One suspects that the Bank will provide a range of scenarios based on differing assumptions about the course of the Covid19 pandemic and the likely economic repercussions of a shorter or longer crisis. 

Many questions are not answered, or even addressed, in these forecast revisions. Will government support programs and a huge increase in deficit spending prevent corporate defaults and a permanent destruction of economic capacity. If debt defaults are too large, will that tigger persistent higher unemployment and unleash deflationary forces? Will Canada's highly productive energy industry be able to recover when government policies are tilted toward "phasing out" fossil fuels? Will financial markets take in stride the coming huge spike in Canada's federal debt-to-GDP ratio, or will investors demand a higher credit risk premium for a country which already has very high levels of household and corporate debt? Will the Bank of Canada's policy interest rate setting stay at the effective lower bound indefinitely, and if so, will bond markets anticipate higher inflation and bond yields? Perhaps the Bank of Canada's crack forecasting team will shed some light on these questions. But probably not.

Having read the Bank of Canada's April Monetary Policy Report, I must admit that I am not surprised that most of the questions posed above were not addressed. As noted in the MPR, the future course of Covid19 is still too uncertain to make projections with any precision. As I suspected, the BoC chose to provide a range of scenarios based on differing assumptions about the course of the pandemic and the eventual relaxation of containment measures. I was surprised, however that while the MPR did provide charts showing a range of plausible projections for the level of real GDP and CPI inflation, it did not provide any numerical projections.

However, from the charts provided by the MPR, we can extract the Bank's most optimistic and most pessimistic projections and they are very surprising. 

First, a digression. When I started my career as an economist straight out of graduate school in 1977, I went to work at The Conference Board of Canada. At the time, the Conference Board had Canada's only private sector quarterly econometric model forecast. The Board had a very strong team of forecasters and its' quarterly forecasts were presented at large conferences for members, quite often with up-and-coming economists from the Bank of Canada in attendance. I worked at the Board from 1977 to 1980, helping out with the forecast and publishing a number of research reports. These forecasts and research reports had lots of charts and graphs. We had a big mainframe computer that could print out the tables with all of the forecast numbers, but computer graphic printers had not yet been perfected. Instead, we had a chart room, which employed numerous graphic artists who toiled all day grinding out the charts using graph paper, rulers, light tables and all the many tools of their trade. Remembering those days, one can use a ruler and a pencil and reverse engineer the Bank of Canada's charts in the MPR to come up with the data points for their most optimistic and pessimistic scenarios.

When one goes to the trouble to do that, one gets a surprise, as shown in the chart below. In the chart, I compare the BoC's projections with the pre-Covid19 path of potential GDP and with forecasts made in late March by TD Economic Research and by the Parliamentary Budget Office which were shown in my previous post.

The surprising thing about the BoC projections is that even the Optimistic projection shows a far deeper plunge in real GDP in the first half of 2020 than the worst private sector forecasts. In the MPR press conference Governor Poloz said that he thought the Optimistic projection was attainable if containment measures started being relaxed in late May or early June. The Pessimistic projection, which contemplates a later relaxation of containment measures, shows the level of real GDP collapsing by more than three times as much as either the worst private sector forecast or the forecast used by the Parliamentary Budget Office when it projected a C$182 billion deficit for FY2020-21.

The BoC's Optimistic real GDP projection works out to be a contraction of about 6.5% in 2020 followed by about a rebound to about 8.5% growth in 2021. The average forecast from the economists of Canada's big banks in early April was for a contraction of about 4% in 2020 followed by a slightly better than 4% rebound in 2021. For comparison, the latest IMF forecast for Canada calls for a contraction of 6.2% in 2020 (very similar to the BoC's optimistic scenario) followed by a 4.2% rebound in 2021 (very similar to the private sector bank forecasts). The BoC's Pessimistic projection is horrendous, calling for a 19% contraction in 2020, followed by a 4% rebound in 2021.  

Another way to view the Bank's projections is to convert them into projections of the output gap, i.e. the gap between projected GDP and potential GDP, which was assumed to be growing at about 1.7% before Covid19. The chart looks similar, but the scale shows that while TD Economics and the PBO expected economic activity to fall about 10% below previous estimates of its' potential, the BoC expects real GDP to fall, optimistically, 15% or, pessimistically, 30% below potential before beginning a quick or slow recovery. In the Optimistic projection, real GDP recovers to near full capacity by the end of 2021. In the Pessimistic projection, real GDP would still be almost 15% below its pre-Covid19 potential at the end of 2021, an outcome which would surely be called a depression. 

No wonder the Bank of Canada decided not to publish numerical projections! Doing so would probably have been a shock to the already battered confidence of Canadian businesses and consumers. It would also have implied a much larger budget deficit than that projected by the Parliamentary Budget Office.    

Canada Post-Covid19

Worldwide confirmed cases of Covid-19 ramped up dramatically in March. As the case count grew, governments around the world imposed draconian, but necessary, public health restrictions which have had the effect of shutting down large swaths of the global economy. This has caused a scramble by economists to revise their forecasts from what was a benignly boring view at the beginning of the year that nothing particularly interesting would happen to the economy in 2020.

In February, when Covid-19 was mainly a Chinese phenomenon, that led to the lockdown of Wuhan and Hebei Province, most economists forecast that the virus would have little impact on global growth and that China's economy would slump in 1Q19 but snap back in V-shaped recovery in 2Q19. However, as the virus spread exponentially across the globe in March, economists began to take it seriously and to take down their growth forecasts and consider the possibilities of U-shaped or even L-shaped recoveries. By mid-month, some economists declared a global recession. By month-end, a debate was developing about whether it would be a Recession or a Depression.

For their part, Canadian economists began adjusting their forecasts in early March and progressively downgraded the growth outlook as the month wore on. The chart below shows how forecasts for Canada's real GDP have changed since late February.

     
The Chart shows real GDP in level terms; it was C$2.1 trillion seasonally adjusted at annual rates in 4Q19. On February 21, the economists at my old employer, JP Morgan, had a close-to-consensus forecast that the economy would grow steadily, if not robustly, at about its' potential rate of 1.7%. By March 13, JPM had downgraded the forecast to show a moderate recession, with growth contracting at annual rates (ar) of -1.5% in 1Q20 and -2.5 in 2Q20, followed by a rebound in growth to about a 3%ar in the second half of the year.

Two weeks later, on March 27, JPM had reassessed the damage and forecast contractions of -5.5%ar and -18.5%ar in the first two quarters of the year, followed by growth averaging 9%ar in the second half. For comparison, Bank of Montreal (BMO) Economics on March 27 forecast contractions of -6.5% and -25%ar in 1Q and 2Q20, followed by a rebound at a stunning 30%ar in 3Q20 and 4% in 4Q. TD Economics made a similar forecast on March 25, but didn't expect as fast a rebound in growth as BMO. 

The convention of stating growth at annual rates confuses people by exaggerating the weakening of the economy. The reality, for those who are not growth afficionados, is that BMO, for example, is forecasting that seasonally-adjusted real GDP will contract by -1.7% in 1Q20 and by -7% in 2Q, followed by a 6.8% rebound in 3Q20 and 1% growth in 4Q20. This results in a full year contraction of real GDP of -3% in 2020. Forecasts for 2021 growth now stand at 2.7% for JPM, 3.5% for BMO and 3.7% for TD. It would be helpful and constructive for economists to stop reporting their quarterly forecasts at seasonally adjusted annual rates and just report the actual contraction of real GDP.

This is not to minimize the hit to the economy, it is just to clarify what these economists are telling us. In fact, their arithmetic points to a very sudden and serious recession. The range of forecasts is fairly large, even though all of the forecasters expect the economy to be recovering by 3Q20. All of the forecasters are assuming that Covid19 cases will peak in 2Q and subside in a manner similar to that experienced in China or South Korea. If new cases take longer to peak or if there is a resurgence of new infections in the autumn, the rebound in real GDP will be slower and take longer than in the current forecasts.

Even if the current forecasts are close to accurate, they point to a significant loss of real output and incomes. The output gap is forecast to widen to the 7-9% of GDP range in 2Q20. Real incomes will likely fall by even more as Canada's terms of trade have fallen sharply due to the drop in crude oil and other commodity prices. Even in the most optimistic forecast, real GDP will not return to its' potential by the end of 2021. BMO forecasts that even six quarters into the recovery, the output gap would still be almost 3% of GDP, while JPM and TD see the gap still at almost 4% of GDP. Forecasters seem to be suggesting that there Covid19 is causing a permanent loss of output and income and a downshift in the future path of the level of real GDP. 

While economists have spent considerable effort attempting to estimate the immediate hit to real GDP, they seem to have spent less time thinking about the impact of Covid19 on inflation. The chart below shows some of the latest inflation forecasts.

Before significant adjustments in forecasts were made, as illustrated by JP Morgan's February 21 forecast, the outlook was for CPI inflation to remain well behaved and to converge to the Bank of Canada's 2% target by the end of 2020 and to remain there through 2021. By March 27, all forecasters had built in a dip in inflation in 2Q20 followed by a steady return to the 2% target or slightly higher by the end of 2021. BMO projects the biggest dip in inflation to just 0.3% over a year ago in 2Q20, and despite their forecast of a sharp snapback in real GDP in 3Q20, still expects inflation to be just over 1%oya in 1Q21. Perhaps because they have been well trained by the Bank of Canada's projections, all forecasters expect inflation to converge to close to target within two years. Yet, as mentioned above, these forecasters still expect an output gap (excess capacity) of between 3 and 4% of GDP by the end of 2021. 

Some forecasters may rationalize this return to target inflation despite a still sizable output gap by assuming that potential GDP estimates will be permanently reduced by the Covid19 crisis. It is not clear why this should be the case. The growth of the labour force is not likely to be affected unless the government indefinitely closes the border to immigration. And there is no reason to mark down potential estimates of productivity unless economists believe that Covid19 will a permanent depressing effect on capital investment. These outcomes are possible, but only likely if the economic shutdown lasts much longer than is assumed in current forecasts.  

Bank of Canada Governor Poloz noted the lowered growth and inflation forecasts as the Bank cut its policy rate to the "effective lower bound" of 0.25% from 1.75% at the end of February. Poloz said that the lowered forecasts he was seeing were little more than arithmetic and promised to unveil new projections on April 15th from the Bank of Canada's forecasting team, which he described as "the best there is". He suggested that more than just doing arithmetic, the Bank of Canada's forecasters would take account of confidence effects and how behavior might change in the post-Covid19 world. One suspects that the Bank will provide a range of scenarios based on differing assumptions about the course of the Covid19 pandemic and the likely economic repercussions of a shorter or longer crisis.

Many questions are not answered, or even addressed, in these forecast revisions. Will government support programs and a huge increase in deficit spending prevent corporate defaults and a permanent destruction of economic capacity. If debt defaults are too large, will that tigger persistent higher unemployment and unleash deflationary forces? Will Canada's highly productive energy industry be able to recover when government policies are tilted toward "phasing out" fossil fuels? Will financial markets take in stride the coming huge spike in Canada's federal debt-to-GDP ratio, or will investors demand a higher credit risk premium for a country which already has very high levels of household and corporate debt? Will the Bank of Canada's policy interest rate setting stay at the effective lower bound indefinitely, and if so, will bond markets anticipate higher inflation and bond yields? Perhaps the Bank of Canada's crack forecasting team will shed some light on these questions. But probably not.    

Even before Covid-19 the Bank of Canada Needed to Ease

The rapid global spread of the Covid-19 virus and the precautionary health measures being taken in many countries to stem the pandemic have created turmoil in financial markets. Most global stock markets are in correction -- down more than 10% from their recent highs. Global bond yields have plunged -- the 10-year US Treasury yield touched a record low of 1.12% on February 28, before closing at 1.16%. The 10-year Canada bond closed at 1.13%, down from a recent high of 1.70% on November 2 and the lower than in January 2015 when the Bank of Canada last cut the policy rate. Commodity prices have plunged as global demand has cratered. The benchmark West Texas Intermediate (WTI) crude oil price has dropped 27.5% to $45.26 from $62.43, its recent high in early January. Western Canadian Select (WCS), Canada's benchmark crude price has fallen to $31.69 from a high of $58 in May 2018. The turmoil in asset markets is a reflection of repricing in highly liquid financial markets reflecting investor's expectations, based on current information, of how activity levels are being affected by containment efforts to halt the global spread of coronavirus.

The spread of Covid-19 is creating a chain reaction of economic effects. The initial outbreak in China, which probably began in December but was not acknowledged until late January, led to public health measures which caused workers to stay away from work, travelers to stop traveling, and consumers to stay away from shops, restaurants and entertainment venues. Coal consumption fell 40% as factories were shut down. Supply chains that depend upon Chinese manufactured goods were interrupted. Shipping volumes dropped sharply. 

Economists have been scrambling to monitor the contraction in economic activity. In the early days, many economists suggested the the impact would be minor, merely causing a slowdown in China's economic growth in 1Q19 that would be fully made up in a V-shaped bounce back in 2Q19. However, as February wore on, it became abundantly clear that the virus had not been contained. Outbreaks in other countries including Japan and South Korea, on passenger ships, and eventually further afield in Iran and Italy made it clear that Covid-19 had become a pandemic, even if the World Health Organization was reluctant to say so. Now, economic activity has stalled in Hong Kong, Singapore, Tokyo, Seoul and Milan. Countries around the world are warning their citizens to prepare for Covid-19 outbreaks. In Canada, the federal health minister has suggested that citizens put together survival kits to see them through the possibility of two weeks or more of self-imposed quarantine.

As time has passed, economists have progressively cut their forecasts for 2020 economic growth and in many cases have acknowledged that a V-shaped rebound in 2Q19 is becoming much less likely as the virus continues to spread internationally.

The Bank of Canada's Dilemma

In January, Bank of Canada Governor Stephen Poloz revealed that the Bank's forecast for growth of Canada's real GDP in 4Q19 had been cut to 0.3% at an annual rate from the October forecast of 1.7%.    The Bank projected a modest rebound in 1Q20  growth to 1.3% and to about 2% in subsequent quarters of 2020. In releasing these projections along with a decision to leave the policy rate unchanged at 1.75%, Governor Poloz said,

All things considered, then, it was Governing Council’s view that the balance of risks does not warrant lower interest rates at this time. In forming this view, we weighed the risk that inflation could fall short of target against the risk that a lower interest rate path would lead to higher financial vulnerabilities, which could make it even more difficult to attain the inflation target further down the road. Clearly, this balance can change over time as the data evolve. In this regard, Governing Council will be watching closely to see if the recent slowdown in growth is more persistent than forecast. In assessing incoming data, the Bank will be paying particular attention to developments in consumer spending, the housing market and business investment.

Since making this statement, real GDP growth in 4Q19 did match the BoC's anemic projection of 0.3% at an annual rate. Early data for 1Q20 has been mixed with housing starts, real exports and total employment modestly firmer in January but with total hours worked, the manufacturing PMI and real imports all down from the 4Q19 average. Activity levels in February will have been depressed by the rail and port blockades by activists protesting the Coastal Gas Link Pipeline. 

Global growth forecasts for 1Q20 have been progressively marked down over the past few weeks as the spread of Covid-19 moved quickly and became an incipient pandemic that was likely to last longer and deal a bigger blow to global activity than originally thought.

If the Bank of Canada was worried in mid-January, before the Covid-19 pandemic began, that the late-2019 slowdown in growth might be more persistent, there can be no doubt that the downside risks to both growth and inflation have increased substantially since then. 

Why the BoC should be easing

Even before the spread of Covid-19 and the precautionary actions that are slowing global commerce, there was strong reason for the Bank of Canada to follow the lead of the US Fed and numerous other central banks since mid-2019 in cutting their policy rates.

Since early May 2018, Canada's commodity prices have been falling. When commodity prices fall, Canada's terms of trade weaken as the prices of our exports fall relative to the price of our imports. Historically, the Bank of Canada has responded to sharp falls in commodity prices and the terms of trade by easing monetary conditions through a combination of lowering the policy rate and allowing the Canadian dollar to weaken against foreign currencies. The Bank last did this in early 2015 when crude oil prices collapsed. 

In the chart below, for the 2014-15 period, the commodity terms of trade, which I define as the Bank of Canada's commodity price index divided by the core CPI, is shown alongside the BoC's measure of Canada's nominal effective exchange rate (CEER). The CEER is shown against all currencies and also against all currencies excluding the US dollar.

As the chart clearly shows, the commodity terms of trade dropped sharply in late 2014 as world and Canadian crude oil prices collapsed. As this occurred, Canada's effective exchange rate weakened because of a weakening of the Canadian dollar versus the US dollar, while excluding the USD, the effective exchange rate actually strengthened until January 2015. In January, the Bank of Canada stunned market participants by cutting the policy rate, which triggered a sharp fall in the effective exchange rate, both including and excluding the USD. The weakening of the CAD helped cushion the blow of the oil price collapse on oil-producing regions of Canada and helped improve the export competitiveness of other sectors and regions of the economy.

Now look at the same chart for the 2018-20 period. 

Once again, the commodity terms of trade peaked in May 2018 before falling sharply in late 2018 as central bank tightening, led by the US Fed, raised recession fears. Slowing growth and the sharp fall in commodity prices, along with a melt-down of global equity markets, caused the Fed and other major central banks to reverse course by cutting their policy rates and, in some cases, adding liquidity by expanding their balance sheets through quantitative easing. The Bank of Canada was an outlier, choosing not to follow suit with rate cuts of its own. The result was that, despite a sharp weakening in commodity prices, Canada's nominal effective exchange rate appreciated. This not only made times more difficult for commodity producing sectors and regions, but also caused a deterioration in the export competitiveness of Canada's manufacturing exports at a time of stagnating global trade. The Bank of Canada, through this period, expressed concern about the risk that high household debt levels posed to financial stability. The BoC made a clear trade-off, attempting to constrain household borrowing, especially mortgage borrowing in Toronto and Vancouver, at the expense of Canada's commodity sector and other export oriented industries.

Since the onset of Covid-19, commodity prices have renewed their decline. The commodity terms of trade have now weakened 27.5% since May 2018, half of the steep decline in 2014-15. The 2014-15, the 52% decline in the commodity terms of trade was cushioned by a depreciation of 22% against the USD, a depreciation of the nominal effective exchange rate of 15%, and an effective depreciation of 7.5% against non-US trading partners. The 27.5% decline of the commodity terms of trade since May 2018 has been accompanied by just a 1.6% depreciation against USD, but a 1.6% appreciation in the nominal effective exchange rate, providing no relief for commodity producers and a deterioration in the competitiveness of other exporters. Alberta, Saskatchewan, Northern BC and Newfoundland are suffering not only from weak commodity prices and regulatory strangulation, but also from a strong exchange rate generated by the BoC's unwillingness to cut the policy rate. Auto plants in Ontario are closing or laying off workers as Canada's competitiveness weakens.

We are just now beginning to see the economic impact of Covid-19. Purchasing managers' surveys showed activity levels collapsed in both the manufacturing and services sectors in China. Declines are also likely to be recorded in Japan, Korea and other Asian countries in February. Measures now being taken in Europe and the United States suggest that as the virus spreads, so too will the economic weakness.

Here in Canada, where hard economic data is published with a lag of up to six weeks relative to the United States, it would be foolish to wait for statistical evidence for the BoC to take action and cut the policy rate. Even without Covid-19, the failure to cut policy rates along with other major central banks has slowed growth and done so at the expense of the weakest sectors and regions of the country.         

Biggest Macro Misses of 2019

I wasn't going to do this. I figured that after doing five years of "Biggest Macro Misses" that I had probably made my point. Economic and financial market forecasts that are rolled out at year end tend to be a poor guide for investment decisions for the year ahead. However, 2019 has seen both some of the biggest macro misses in years, but at the same time some remarkably good predictions of global equity market performance. 

So, as another year comes to a close, here I go again. For probably the last time, I will review how the macro consensus forecasts for 2019 that were made a year ago fared. 

Each December, I compile consensus economic and financial market forecasts for the year ahead. When the year comes to a close, I take a look back at the forecasts and compare them with what we now know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move --  sometimes dramatically --  when different economic outcomes transpire. When we look back, with the benefit of hindsight, we can see what the macro surprises were and interpret the market movements the surprises generated. It's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to judge what were the macro drivers of 2019 investment returns and to assess whether they are sustainable.

Real GDP

A year ago, forecasters were overly optimistic about 2019 real GDP growth in the major economies. Weighted average real GDP growth for the twelve countries we monitor is now expected to be 3.0%, falling well short of the consensus forecast of 3.6% made a year ago. In the twelve economies, real GDP growth fell short of forecasters' expectations in eleven and met expectations in just one. The weighted mean absolute forecast error for the twelve countries was 0.6 percentage points, the biggest miss since 2015.

Based on current estimates, 2019 real GDP growth for Developed Market (DM) economies was 1.8% or 0.4% below last December's forecast, while growth for the Emerging Market (EM) economies that we follow was 4.6% or 0.7% below the forecast. Mexico, India, Australia and Korea had the biggest downside misses. 

CPI Inflation

Just as for global growth, the consensus forecast for global inflation for 2019 was off the mark, overestimating inflation in most countries. Nine of the twelve economies are on track for lower inflation than forecast, while inflation was higher than expected in just two countries. The weighted mean absolute forecast error for 2018 for the 12 countries was 1.0 percentage points, again the biggest forecast misses since 2015.

The biggest downside misses on inflation were for Mexico (-1.6 pct pts), Korea (-1.5), the Eurozone (-1.0) and Brazil (-0.9). The biggest upside misses were for India (+2.8 pct pts) and China (+1.9), where food prices rose much more than expected.

Central Bank Policy Rates

In 2019, economists' forecasts of central bank policy rates missed badly. Ten of the twelve central banks either unexpectedly cut their policy rate or failed to hike their policy rate by as much as forecast. Two central banks met expectations by standing pat.

In the DM, the Fed was expected to hike the policy rate by 75 to 100 basis points but instead did a U-turn and cut rates by 75bps. Most other central banks followed the Fed's lead, eschewing rate hikes and cutting rates instead. Japan's BoJ  and China's PBoC met expectations by leaving their policy rates unchanged. The Bank of Canada and the Bank of England held rates steady rather than delivering expected rate hikes. Policy rates fell much more than expected in most EM economies, even in India and China where inflation surprised to the upside. 

10-year Bond Yields

Unfortunately, I was unable to collect meaningful 10-year bond yield forecasts for EM economies last year, so I will just compare DM forecasts with actual outcomes for 10-year yields. 

For a second consecutive year, in all six DM economies that we track, 10-year bond yields surprised strategists to the downside. The US 10-year Treasury yield as expected to rise 55bps in 2019 as the Fed was expected to continue to tighten. Instead, US growth and inflation were weaker than expected, The Fed eased and the 10-year Treasury yield fell over 90bps. The weighted average DM forecast error was -1.22 percentage points, the biggest downside average miss since I began doing this in 2014. The biggest country miss was in Australia (-1.87 pct pts). The Aussie bond yield error was bigger than the year-end bond yield (1.60%). In the EM, bond yields also fell as global growth and inflation disappointed. 

Exchange Rates

With the Fed doing a policy U-turn in early 2019, most exchange rate forecasts were upset. How currencies fared depended in large part on the degree to which other central banks matched the Fed's policy shift. All of the major currencies were weaker than expected against the US dollar. The weighted mean absolute forecast error for the 11 currencies versus the USD was 3.5%.

A year ago, most forecasters thought that after the USD had outperformed all expectations in 2018, other major currencies would rebound somewhat. Weaker than expected growth and inflation kept the ECB in ultra-accommodative mode and the Euro weakened rather than strengthened. Australia was another case where growth and inflation badly undershot expectations and the RBA responded by unexpectedly easing by as much as the Fed, sinking the Aussie dollar. In contrast, the Bank of Canada kept it's policy rate steady despite weaker than expected growth and the result was a stronger than expected Canadian dollar.    

The biggest FX forecast misses for the DM economies were for the Euro (which was 7.4% weaker than expected) and the Australian Dollar (-6.9%). Among EM currencies, China and India saw depreciations that were in line with expectations, while Mexico and Russia experienced appreciations that were larger than expected as oil prices firmed. 

Equity Markets

News outlets gather equity market forecasts from high profile US strategists and Canadian bank-owned dealers. A year ago, after a sharp global equity market correction in 4Q18, equity strategists were optimistic that North American stock markets would post a strong rebound in 2019. As shown below, those forecasts called for 2019 gains of 21% for the S&P500 and 13% for the S&PTSX Composite. They were right, but for the wrong reason. Global growth and inflation surprised forecasters to the downside, causing the Fed and other central banks to do a policy U-turn. Both bond and equity markets surged on the unexpected central bank reversal. 
  

As of December 29, 2018, the S&P500, was up 30.3% year-to-date (not including dividends) for an error of +8.9 percentage points. The S&PTSX300 was up 20.7% for an error of +7.7 percentage points.

Globally, after horrible performance in 2018, stock markets rallied back along with US equities. US equities generally had more modest losses in 2018, followed by bigger gains in 2019 than other global equity markets. 

Investment Implications

In 2019, global macro forecast misses were the biggest since 2014-15. Global growth and inflation were both weaker than expected, but an unexpected policy U-turn by global central banks resulted in unexpectedly strong returns for bonds and an even bigger than expected rebound in global equities from the late-2018 correction.  

For Canadian investors, the appreciation of CAD against the USD meant that returns (in CAD terms) on foreign equities and government bonds were reduced if the USD currency exposure was left unhedged. US equities still outperformed Canadian equities in CAD terms, but Canadian equities outperformed most other global equity markets if foreign currency exposure was left unhedged. Meanwhile, Canadian bonds outperformed US Treasuries and other foreign government bonds in CAD terms despite the lack of policy easing by the BoC.

As 2020 economic and financial market forecasts are rolled out, it is worth reflecting that, for a variety of reasons, such forecasts have been a poor guide to investment decisions for several years running. While forecasters' are once again optimistic in light of the partial trade truce between the US and China, the lesson of 2019 is that forecasters have very limited ability to provide actionable investment guidance. 2020 will undoubtedly once again see some large consensus forecast misses as new surprises arise. 

Global ETF Portfolios: 2018 Returns for Canadian Investors

In 2018, aggregate global growth and inflation matched forecasters expectations, but portfolio returns fell far short of what was expected a year ago. At that time, the consensus forecast for global growth was the most optimistic in years and central banks were expected to continue on the path of unwinding monetary stimulus. The expectation among global strategists was for positive single-digit equity returns and weak bond market returns, consistent with consensus views that strong, synchronized global growth, Trump's tax cuts, and central bank withdrawal of stimulus would support equity returns while depressing bond returns. That is not what happened!

The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavor, we track various portfolios made up of different combinations of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios. 

Since we began monitoring our Global ETF portfolios at the end of 2011, we have found that the global portfolios we monitor have all vastly outperformed a simple all-Canada 60/40 portfolio. this proved true once again in 2018.

A stay-at-home Canadian investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 2018 total return (including reinvested dividend and interest payments) of -5.2% in Canadian dollars. This virtually wiped out the all-Canada portfolio gain of 2017. All of our global ETF portfolios outperformed the all-Canadian portfolio in 2018. 

Global Market ETFs: Performance for 2018

In 2018, with the CAD depreciating almost 8% against USD, over 4% against the JPY and relatively unchanged against the Euro, the best global ETF returns for Canadian investors were in US government bonds and gold. The worst returns were in Eurozone, Emerging Market and Canadian equities. The chart below shows 2018 returns, including reinvested dividends, for the ETFs tracked in this blog. The returns are shown in USD terms (green bars) and in CAD terms (blue bars).

Only one of the 19 Global ETFs that we track posted a positive USD total return in 2018. That was TLH, the Long-term (10-20yr) US Treasury Bond ETF, which returned +0.4% if monthly distributions were reinvested.

In CAD terms, returns on unhedged foreign currency ETFs were boosted by the depreciation of the Canadian dollar. The best gains were in the Long-term US Treasury Bond (TLH) which returned 8.8% in CAD terms and the US Treasury Inflation Protected Bonds (TIP) which returned 7.1%. Other gainers in CAD terms were the Non-US Government Bonds (BWX), the Gold (GLD), the US High Yield Corporate Bond (HYG), the US Investment Grade Corporate Bond (LQD). The only equity ETF to make a positive return in CAD terms was the S&P500 (SPY) which returned 3.5%. Small positive returns were also made in the USD Emerging Market Bond  (EMB), the World Inflation Protected Bond (WIP), the Canadian Corporate Bond (XCB) and the Canadian Long Bond (XLB).  

The worst performers in CAD terms were the Eurozone Equity ETF (FEZ) which returned -8.7%, the Emerging Market Equity (EEM) -8.1%, and the Canadian Equity (XIU) -7.8%. Other losers were the Japanese Equity (EWJ), the Commodity ETF (GSG), and the US Small Cap Equity (IWM).

Global ETF Portfolio Performance

In 2018, the global ETF portfolios tracked in this blog posted mixed returns in CAD terms when USD currency exposure was left unhedged, but negative returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.

A simple Canada only 60% equity/40% Bond Portfolio returned -5.2%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned -1.5% in CAD terms when USD exposure was left unhedged, and -5.6% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 0.5% if unhedged, but had a negative return of -3.8% if USD hedged.

Risk balanced portfolios outperformed in 2018 if left unhedged, but performed poorly if USD exposure was hedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 2.1% in CAD terms if USD-unhedged, but lost 5.6% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 1.8% if USD-unhedged, but lost 4.4% if USD-hedged.

Four Key Events of 2018

In my view, there were four key economic and policy developments that left a mark on portfolio returns in 2018. The first was the interaction of the fiscal stimulus provided by President Trump's tax cuts and Federal Reserve's determination to normalize US monetary policy. The second was Trump's aggressive approach to trade policy, first in NAFTA negotiations and then in tariffs targeting China. The third was the increasing divergence between stronger than expected US growth and weaker than expected growth outside the US. The fourth was the Government of Canada's mismanagement of regulatory policies governing the building of pipelines to provide access for Canadian oil to world markets. 

After a promising January, both bond and equity markets stumbled badly in February as an uptick in US wage growth prompted markets to price in more aggressive tightening by the Fed. At the same time, Trump threatened to pull out of NAFTA unless Canada and Mexico got serious about accepting US negotiating demands. As the wage uptick proved temporary and NAFTA negotiations resumed, Trump implemented steel and aluminum tariffs and began the process of ratcheting up tariffs on China. In the summer, Trump threatened to impose 25% tariffs on vehicles produced in Canada and Mexico, if they wouldn't agree with his NAFTA demands. Through this period, Emerging Market equities and currencies fell sharply. As global growth stumbled in 3Q, with both the Eurozone and Japan posting real GDP declines, weakness in equity markets spread to Europe, Japan and Canada. Slowing global growth, including in China, weakened commodity prices. Crude oil prices fell on slowing global demand and booming US supply. Canadian oil prices tanked, as the rising Canadian oilsands production was shut in by inadequate pipeline capacity. As risk markets sold off, volatility rose, and inflation plateaued, both the Fed and the Bank of Canada continued to signal steady withdrawal of monetary stimulus. Meanwhile, as the Republicans lost control of the House of Representatives, Trump continued to ratchet up tariff pressure on China, hoping to force a deal. 

The impact on portfolio returns is clearly shown in the above chart. All portfolios stumbled in February-March, but recovered through the spring into mid-summer. Both US and Canadian equity equity markets managed to put in record highs as bond yields rose. The combination of slowing global growth, rising US-China trade frictions and central banks apparent unconcern about market volatility, proved a trifecta that led to the the sharp 4Q equity market correction and a muted bond market rally. When the Fed tightened for the fourth time of the year in December and Chairman Powell suggested that Fed balance sheet reduction was on auto pilot, it only added to the huge selloff in US  and global equities in December. Only then did Fed officials begin to signal some flexibility on the monetary policy. But by this time, the damage to risk markets was done. 

From their August highs in the +5 to 6% range, year-to-date returns for Canadian investors in Global ETF portfolios shrank to the -2 to +2% range in the final four months of the year. The All Canada Portfolio return sank from +3% in mid-July to -5% by yearend.

Looking Ahead 

As we enter 2019, two crucial questions face markets. The first is whether "The Great Unwind" of unconventional monetary policy that began in mid-2017 will proceed as signaled by the FOMC or whether faltering momentum in the global economy will force central banks to pause indefinitely or even reverse course. The second is whether the US-China trade dispute will lead to a face-saving ceasefire or to an all-out trade war.  The two issues are inter-related. Withdrawal of stimulus by the Fed spills over into tighter global financial conditions, pressuring China's highly leveraged economy. Trade tensions and tariff hikes weaken global growth and add to coast pressures, a toxic mix for equity markets. 

While the consensus outlook expects slowing but still solid global growth in 2019, markets do not currently share most economists view of a "soft landing" and central banks withdraw stimulus. The best hopes for stronger portfolio performance for Canadian investors in 2019 would be a US-China trade truce, a Fed that pauses and reasserts "data dependence" as key for additional monetary policy normalization, and a U-turn in Canadian government policy toward resource development and transportation. If these hopes materialize, 2019 could be a very good year for investors. If not, the last four months of 2018 will likely prove to be just the beginning of a sustained bear market in risk assets.

Biggest Global Macro Misses of 2018

As another year comes to a close, it is time to review how the macro consensus forecasts for 2018 that were made a year ago fared. Each December, I compile consensus economic and financial market forecasts for the year ahead. When the year comes to a close, I take a look back at the forecasts and compare them with what we now know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move --  sometimes dramatically --  when a different outcomes transpire. When we look back, with 20/20 hindsight, we can see what the macro surprises were and interpret the market movements the surprises generated. It's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to understand the macro drivers of 2018 investment returns and to assess whether they are sustainable.

Real GDP

In 2018, forecasters accurately forecast global real GDP growth. Weighted average real GDP growth for the twelve countries we monitor is now expected to be 3.7%, exactly matching the consensus forecast of 3.7% made a year ago. While the global growth forecast was bang on, the individual country GDP forecasts were not. In the twelve economies, real GDP growth exceeded forecasters' expectations in just three and fell short of expectations in nine. The weighted mean absolute forecast error for the twelve countries was 0.4 percentage points, about the same as the 2017 error.

Based on current estimates, 2018 real GDP growth for the US exceeded the December 2017 consensus forecast by 0.5 percentage points (pct pts). Growth also slightly exceeded consensus expectations in Australia and China. The biggest downside misses on growth for 2018 were for Brazil (-1.5 pct pts), Japan (-0.7), Russia (-0.6), the Eurozone (-0.3), and India (-0.3). On balance, a big upside miss on US growth was offset by downside misses in other economies.

CPI Inflation

Just as for global growth, the consensus forecast for global inflation for 2018 was very accurate. Average inflation for the twelve countries is now expected to be 2.4% compared with a consensus forecast of 2.4%. And just as for growth, upside misses just offset downside misses. Six of the twelve economies are on track for higher inflation than forecast, while inflation was lower than expected in six countries. The weighted mean absolute forecast error for 2018 for the 12 countries was 0.4 percentage points, down from a 0.6% average miss last year.

The biggest downside misses on inflation were in India (-1.9 pct pts), and the UK (-0.3). The biggest upside miss on inflation were in Mexico (+1.1 pct pts) and the Eurozone (+0.6%).

Central Bank Policy Rates

In 2018, economists' forecasts of central bank policy rates were, on balance, slightly too high. Four central banks hiked their policy rate by more than expected while six central banks hiked less than expected.

In the DM, the Fed hiked the Fed Funds rate four times, one more than the consensus expected. The ECB and the BoJ met expectations by leaving their policy rates unchanged. The Bank of Canada and the Bank of England hiked slightly less than the consensus expectation. The Reserve Bank of Australia remained on hold instead of hiking once as the consensus expected. In the EM, as usual, the picture was more mixed. Brazil's central bank was able to cut its policy rate more than expected. Russia was expected to cut its policy rate but was unable to do so. In China, the PBoC stayed on hold, as expected, but did cut reserve requirements as the economy struggled to meet the government's growth target. India's RBI was expected to remain on hold in 2018, but had to raise its' policy rate. Mexico extended the trend of late 2016-17, tightening more than expected as inflation rose in response to the weakening of the Mexican Peso. 

10-year Bond Yields

In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. 

In all six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.30 percentage points, the same as for 2017. The biggest misses were in Australia (-0.74 pct pts), Canada (-0.57), the Eurozone (proxied by Germany, -0.55), the UK (-0.35 pct. pt.). In the EM, the picture was mixed as bond yields were lower than forecast in Brazil (-1.78 pct pts) and Korea (-0.75). However, bond yields rose more than expected in Russia (+1.91), Mexico (+1.20) and India (0.36).

Exchange Rates

All of the major currencies were weaker than expected against the US dollar. The weighted mean absolute forecast error for the 11 currencies versus the USD was 7.5%.

The USD was expected to strengthen following the election of Donald Trump as President. In 2017, however, USD unexpectedly weakened reflecting early delays in implementation of Trump's promised tax cuts, hesitation to tighten by the Fed, unexpected tightening by some other central banks and ebbing political uncertainties in emerging economies. In 2018, as Trump's tax cuts took effect, the Fed hiked four times and shrank its' balance sheet, and Trump began his strategy of raising tariffs to pressure trading partners into more advantageous trade arrangements, the USD outperformed all expectations.

The biggest FX forecast misses for the DM economies were for the Canadian Dollar (which was 11.4% weaker than expected), the UK Pound (-9.3%), the Australian Dollar (-8.5%) and the Euro (-8.0%). EM currencies also weakened sharply against USD, led by the Russian Ruble (-17.2%), Brazilian Real (-15.5%) and Indian Rupee (-6.7%). 

Equity Markets

News outlets gather equity market forecasts from high profile US strategists and Canadian bank-owned dealers. A year ago, equity strategists were optimistic that North American stock markets would turn in a modest, if unspectacular, positive performance in 2018. This call was far off the mark. As shown below, those forecasts called for 2018 gains of 5.7% for the S&P500 and 4.9% for the S&PTSX Composite.
  

As of December 21, 2018, the S&P500, was down 9.2% year-to-date (not including dividends) for an error of -14.9 percentage points. The S&PTSX300 was down 14.0% for an error of -18.9 percentage points.

Although global real GDP growth, global inflation and major central bank actions were close to consensus forecasts, the divergences from consensus expectations across countries proved a toxic mix for equities. Stronger than expected US growth and a slight uptick of inflation were met with a slightly quicker normalization of the US policy rate and a steady reduction in the size of the Fed's balance sheet. As the Fed persisted with plans to continue tightening amid slowing growth in Europe, Japan and Emerging Markets, equity markets fell like dominoes. Declines began in EM, spread to Europe and Japan, and finally reached US equity markets in the final two months of 2018. 

Globally, stock market performance (in local currency terms) was horrible.  The Eurozone and Canada led declines in DM equity markets. China, Korea and Mexico led decliners in EM markets. Brazil and India, bucking the global trend, posted gains.  

Investment Implications

In 2018 global macro forecast misses were once again quite different from those of recent years. The accuracy of global growth and inflation forecasts masked unexpected divergences in growth and inflation from expectations for individual countries. Stronger than expected US growth, faster than expected Fed tightening and Trump's tariff increases saw the USD strengthen against all of the major currencies. This mix was particularly difficult for EM economies, including China, with large amounts of USD-denominated debt. As EM economies slowed, crude oil and other commodity prices fell sharply, dimming prospects for countries like Canada and Australia. 

Stronger than expected growth had US stocks outperforming bonds for most of the year. Market concerns that the Fed would continue tightening even as growth outside the US was faltering contributed to the sharp fall in global equity prices in 4Q18. By year end, both US equity and bond prices had fallen, but bonds outperformed as risk aversion took hold.

For Canadian investors, the depreciation of CAD against the USD meant that returns (in CAD terms) on government bonds denominated in US dollars were boosted if the USD currency exposure was left unhedged. The only slight positive returns for Canadian investors came in Canadian and unhedged foreign bonds. The outperformance of globally diversified portfolios over stay-at-home Canadian portfolios continued in 2018. 

As 2019 economic and financial market forecasts are rolled out, it is worth reflecting that, for a variety of reasons, such forecasts have been a poor guide to investment decisions for several years running. While forecasters' optimism about global growth remains in place, cracks are now forming. 2019 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. 

Last year in this space, I said: 

The 2017 macro surprises, higher than expected growth and lower than expected inflation, are now being built in to 2018 views. This actually increases the chances of disappointments that are negative for equities and other risk assets. 

Although it took until late in the year, those disappointments did arrive in 2018. This has left the global economy and financial markets in an uncertain and somewhat precarious position heading into 2019. With central banks focussed on "normalizing" monetary policy, the buoyant financial market performance that accompanied massive expansion of central bank balance sheets is increasingly looking like it's going into reverse.