Poloz and Yellen: Rookie Mistakes?

In a speech in Halifax on March 18, Bank of Canada Governor Stephen Poloz gave a downbeat assessment of both near-term and longer-term growth. In the Q&A following the speech, Poloz would not rule out the possibility that the BoC's next move might be a rate cut and the Canadian dollar promplty dropped 0.7%. The following day, Fed Chair Janet Yellen stumbled through a press briefing following the Fed meeting in which quantitative forward guidance was replaced by qualitative guidance. Markets interpreted the Fed statement and Yellen's comments as either more hawkish or just more uncertain and the Canadian dollar dropped another 0.9% to its lowest level in four years.

While the statements of both rookie central bank governors were mostly sensible and moderate, they clearly heightened market uncertainty future monetary policy in both countries and the increased uncertainty reverberated through financial markets.

Poloz speaks of Secular Stagnation

Poloz's speech has the unfortunate title, "Redefining the Limits to Growth", harking back to the 1972 polemic, "The Limits to Growth" published by the Club of Rome. The speech had nothing to do with the Club of Rome's Malthusian warning that exponential growth in a world of finite resources would lead to overshooting and collapse. Instead, the basic message was that demographic forces and the hangover from the global financial crisis together are putting limits on economic growth. 

For Canada, Poloz explained there is an interplay between the aging and the beginning of the retirement of the baby boom generation, the demand for housing and the path of productivity growth. Strong housing growth and weak business investment have lowered productivity growth. The retirement of the baby boomers is slowing labour force growth. As a result, Canada's potential growth rate has slowed to 2% or possibly a bit less. Poloz noted that there is some slack in the economy and said that "we expect growth to approach 2.5% over the next over the next couple of years … This is why we say that it will take a couple of years for us to close our excess capacity gap and get inflation back to near our 2 per cent target". This is quite conventional Bank of Canada thinking which seems to ignore the comments, made by outgoing Senior Deputy Governor Tiff Macklem just two weeks earlier, that the relationship between the output gap and the rate of inflation is small and statistically insignificant. 

Poloz also invited his audience to "dive in" to the argument made by some analysts, notably Larry Summers, that suggests the global economy may be facing a long period of secular stagnation. Poloz opines that "the possibility of secular stagnation needs to be taken seriously… it suggests that interest rates may remain lower than we have experienced in the past for a longer period, until some of these long-term forces dissipate. One specific consequence would be that even extraordinarily low policy interest rates could prove to be less stimulative than in normal circumstances."

Yellen's Fed shifts from Forward Guidance to Fuzzy Guidance

The March 18-19 Federal Open market Committee (FOMC) meeting was widely anticipated for two reasons. It would be the first meeting chaired by Janet Yellen and it was expected that the Fed would shift from the quantitative forward guidance implemented by the Bernanke Fed in 2012 to some form of qualitative guidance. The reason for the shift was that the US unemployment rate had fallen faster than expected to close to the 6.5% that the Fed had earlier indicated would require contemplation of tightening policy. At the same time, US inflation has fallen to just over 1% and the Fed had already made it clear that while its plan to taper the stimulus provided by its bond purchases would proceed, that it expected the policy rate to remain extraordinarily low for an extended period.

The FOMC statement announced that with the unemployment rate approaching 6.5%, the Committee is updating it's forward guidance as follows: 

• "In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments."

The statement also said that, 

• "The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements", and  
•  "It will likely be appropriate to maintain the current target range for the federal fund rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the policy committee’s 2% longer-run goal. 

In the press conference, when pressed to define "a considerable time", Yellen said, "Something on the order of six months, or that type of thing". Although the response was not substantially different from what markets have been expecting, the US stock market fell sharply on the comment.

Then there was the matter of the "dot plots". When the Fed updates its forecasts it polls members of the FOMC as to where they expect the Fed funds rate to be at points in the future. Yesterday's release showed that there has been a shift toward expectations that rates will rise more rapidly than was expected in December. The comparison of the dot plots out to the end of 2016 is shown below.

When asked about the implication of the dot plots at the press briefing, Yellen said “I think that one should not look to the dot plot so to speak as the primary way in which the committee wants to or is speaking about policy to the public at large … I would simply warn you that these dots are going to move up and down over time, a little bit this way or that,” she added.

Yellen faced a tough task in having to explain the change in the forward guidance, the change in the dot plots and the notion that nothing had changed in the Committee's intentions. Market movements reflected not so much a change in the Fed's view as an increase in the market's uncertainty about how to interpret the Fed's statements.

The Fallout

Stephen Poloz' limits to growth speech and Janet Yellen's comment equating a considerable time to about six months, when taken together, give the appearance of growing divergence in Canadian and US monetary policy thinking. The somewhat loose comments made by both central bank governors might be considered rookie mistakes. It is unlikely that it was the intention of either Governor to have as big a market impact with their statements as they received. However, in a world where policy rates have been held at unusually low levels for an extended period, and where asset prices and exchange rates have become highly sensitive to even the slightest shift in central bank language, it is not surprising that the two new Governors rattled the markets with their comments.

Why So Paranoid About Canada’s Housing Market?

On February 2, the usually careful Financial Times breathlessly reported that “Pimco, the world’s biggest bond investor, has slashed its exposure to Canada – one of its top country holdings – as it predicts home prices will start to fall this year amid broader concerns that it could be the next global housing bubble ready to burst”. Mr. Ed Devlin, who oversees Canadian investments for Pimco, told the FT that “the fund has been bearish on Canadian housing for some time and expects a decline in housing activity and prices this year as mortgage credit tightens and borrowing rates increase”.

The article goes on to say that, “banks, including Goldman Sachs and Deutsche Bank have pointed to an overvaluation of Canada’s housing market, but few large funds have been explicit about cutting their positions”.

Sounds pretty scary, doesn’t it? But is it true? Has Pimco done its homework?

 

•   Is there evidence that Canada’s housing market is more overvalued than those in other countries?
•  Will mortgage credit tighten and borrowing rates increase in Canada more than in other countries?
•  What will trigger a serious housing downturn in Canada relative to other housing markets?

Is Canada’s Housing Market Relatively Overvalued 

Many economists and urban planners use affordability indexes to determine whether housing is overvalued. The Demographia International Affordability Survey, which is in its tenth year, provides a wealth of up-to-date comparisons of median house prices relative to household income in major cities in the US, UK, Japan, Hong Kong, Singapore, Australia, New Zealand and Canada.

The summary chart of Demographia’s research is shown below. It compares affordability of housing in Australia, New Zealand, Canada, US and UK in cities with populations over one million included in the Demographia surveys in 2005 and 2013. Canada was the most affordable housing market among this set of countries by a wide margin in 2005, when the median house price of housing in Toronto, Montreal, Vancouver, Edmonton and Ottawa was 3.4 times the median household income in these cities. In the other four countries, the median multiples were 5.4 in the UK, 6.0 in Australia, 6.2 in the US and 6.3 in New Zealand. 

Source: 10^th Annual Demograhia International Housing Affordability Survey, March 2014

With the bursting of the US and UK housing bubbles in the financial crisis, housing median multiples have fallen in 2013, while in commodity-producers Australia, New Zealand and Canada, multiples have increased. While Canada's multiple has increased most,  at 4.8 in 2013, it is still low relative to the other countries with New Zealand at 6.9, Australia at 6.3, US at 5.3 and UK at 4.7. 

How Do Cities around the World Compare?

Using the Demographia data, we can calculate which are the most expensive housing markets in the countries surveyed. We have translated the median prices for each city into Canadian dollars and then used Demographia’s estimates of median square footage of houses in the various countries to calculate the cost of houses in Canadian dollars per square foot. I have added estimates for Beijing and Moscow derived from other sources. The results are shown in the chart below. Canadian cities are shown with red bars, US cities are shown with blue bars and cities in other countries are shown as green bars. (If you find the chart hard to read, zoom in once or twice to be able to read the city names.)

By this measure, Hong Kong (C$1150/sq.ft.), London (C$750), Beijing (C$580), Singapore (C$460), Dublin (C$420), Devon (C$400), and Moscow (C$385) rank as the world's most expensive cities. Vancouver is the most expensive Canadian city (C$360), slightly less expensive than Moscow and slightly more expensive than San Jose, California (C$340), Sydney (C$315), and San Francisco (C$300). Toronto is Canada’s second most expensive city (C$245), slightly less expensive than Santa Barbara (C$270) and Melbourne (C$260), and slightly more expensive than Canberra (C$244), Auckland (C$240) and Oxnard, California (C$235). Calgary (C$210) is just slightly less expensive than Napa, California (C$220) and Tokyo (C$215) and slightly more expensive than San Diego (C$205) and Brisbane (C$195). Further down the list, Edmonton and Ottawa (both C$165) are slightly less expensive than Christchurch and slightly more expensive than Aberdeen. Toward the most affordable end of the spectrum, Moncton (C$77) is slightly less expensive than Willmington (C$79) and slightly more expensive than Cincinnati (C$60).

The point of all of these numbers is that Canadian house prices are quite comparable to those in the US and many other countries. It is worth noting that Canada’s three most expensive big cities, Vancouver, Toronto and Calgary all placed in the top 10 in the Economist Intelligence Unit’s most liveable cities list as did three of Australia’s most expensive cities, Sydney, Melbourne and Perth. None of the cities that are more expensive than Vancouver, placed in the top ten. No US city placed in the top ten. This suggests that there is still good relative value in Canadian house prices.

Why is Pimco so paranoid about Canada? 

Mr. Devlin argues that Canadian house prices will fall as mortgage credit tightens and borrowing costs rise. But global interest rates tend to move quite closely together and tend to be driven by movements in US rates. It doesn’t seem likely that Canadian housing prices will be hit any harder than Hong Kong, US, UK, Australian or New Zealand house prices by a generalized rise in global interest rates. Recently, the Bank of Canada has been more dovish than the US Fed and Canadian borrowing costs may move up slower than those in the US and UK. It is widely recognized that Canada has maintained more prudent lending standards than did the US and UK prior to their housing market downturns.

What could trigger a Canadian Housing market downturn? 

The possible triggers for a serious Canadian housing market downturn are:

•   A Canadian recession that results in a sharp rise in unemployment,
•   A sharp pickup in Canadian inflation that results in a sharp rise in borrowing costs,
•   A significant sell-off in commodity prices (possibly caused by a global recession or a hard-landing in China) that hurts economic activity and land prices in Canada’s resource producing provinces.

Pimco is not forecasting any of these possible triggering events. Instead, it seems to be arguing that Canada’s housing market will roll over on its own. It is not clear why Canada’s most affordable cities would experience a sizable housing price correction. And it is not clear why Vancouver, Toronto and Calgary would experience a sharp downturn while Hong Kong, London, San Francisco or Sydney would not.

Global central bank policies of low interest rates and massive liquidity provided by quantitative easing have affected all global housing markets, pushing up the value of real assets such as houses relative to the value of money. When central banks withdraw from their extremely easy monetary policies, housing markets in all countries may experience a slowing or a more serious correction. But there is no reason to single out Canada, as the Financial Times did, as “the next global housing market ready to burst”.     

Canadian ETF Portfolios: February Review and Outlook

In February, global equity markets rebounded from their January selloff, which was touched off by continued tapering of QE by the Federal Reserve, turmoil in emerging markets, and disappointing US economic data. Prior to the correction, equity market sentiment had been sky-high on what was viewed as and improving US and global growth outlook. So what triggered the equity rebound?

Emerging markets concerns abated somewhat, although risks remain high in several countries. US economic data continued to disappoint but markets seemed to shrug the clear signs of slowing as primarily weather related. The Citi G10 Economic Surprise Index, which had surged into early January, fell back into negative territory by the end of the month. Janet Yellen took over as Chair of the Federal Reserve and the Fed continued on a steady tapering path, but markets remained comfortable that tapering does not mean tightening. Against this backdrop, the S&P500 recovered from its January dip to finish February at a record high. 

Energy prices rallied on frigid North American weather and geopolitical risk, as the WTI futures price rose to $103/bbl by February 28 from $98/bbl at the end January.

Gold continued to rebound, as geopolitical risks increased and weak data suggested tapering would be gradual, with the price reaching $1329 at the end of February, up from $1240 at the end of January. Gold, the worst performing asset in 2013, is the best performer in 2014 to date.

With crude oil, gold and natural gas prices all strengthening in in February, the Canadian dollar firmed a bit after its sharp drop in January. The Fed’s decision to proceed cautiously with tapering, combined with the Bank of Canada’s concerns about downside risks to inflation, tempered the Canadian dollar’s response to stronger energy and gold prices, with the C$ rising 0.6% against the US$ in January, as USDCAD fell to 1.1064.

Global Market ETFs

Monthly Performance for February

Stabilization of EM turmoil, continued weak (weather-impacted) US economic data and continuity at the Fed generated positive returns for most all classes in February. The S&P500 recovered its January loss, closing February at a record high 1859, up from 1783 at the end of January and 1842 at the end of December. Global equity ETFs posted positive returns in February. Most major markets gained in local currency terms and, despite the firming of the C$, Canadian investors saw solid global equity performance in CAD terms, which included the Eurozone (FEZ), which returned 5.9% in CAD terms, US (SPY) +4.0%, Canada (XIU) +3.9%, Emerging Markets (EEM) +2.8%, and Japan (EWJ) +1.9%. US small caps (IWM) returned +4.2%, slightly outperformed US large caps in February.

Commodity ETFs performed well. The Gold ETF (GLD) returned 5.7% in CAD terms, while the GSCI commodity ETF (GSG) returned 4.2% as commodity price strength outpaced C$ firming. 

Most Global Bond market ETF returns added to their January gains, with EM bond ETFs outperforming DM bond ETFs. Canadian bonds (XBB) returned +0.4% in February. Non-US global government bonds (BWX) posted a return of +1.7% in CAD terms. Emerging Market bonds outperformed in February as USD-denominated bonds (EMB) returned +2.9%, while EM local currency bonds (EMLC) returned +2.4% in CAD terms. The weakest performance came from US bond ETFs which hurt Canadian investors as the C$ strengthened. US long bonds (TLH) returned -0.03% in CAD terms. 

Inflation-linked bonds (ILBs) posted mixed returns in February. Canadian RRBs (XRB) returned +0.4%, US TIPs (TIP) returned -0.1% in CAD terms, and non-US ILBs (WIP) returned +2.3%.

US investment grade (LQD) and high yield (HYG) bonds posted positive returns in CAD terms, returning +0.6% and +1.7% respectively. Canadian corporate bonds (XCB) returned +0.5%.

Global ETF Portfolio Performance for February 2014

In February, Canadian ETF portfolios posted solid performance, adding to the January gains.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 3.1% in February to be up 4.1% year-to-date (ytd). A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned 2.2% in February to be up 3.4% ytd.

Risk balanced portfolios, which performed well in January, added to their gains in February. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 3.1% in February, bringing its year-to date gain to 7.5%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 2.3% in February to be up 5.8%ytd.

Outlook for March

February turned out to be a rebound month after global equity markets suffered a significant sell-off in the last two weeks of January. Equities, bonds, I-L bonds and commodities all posted gains in February as concerns about turmoil in emerging markets abated somewhat and Janet Yellen reassured markets that the Fed would slow the tapering if the economy slows.

Key developments that markets will be watching in March will include:

·  The Winter Olympics detracted traders’ attention from unsettling developments in Ukraine through mid-February. After the athletes returned home, however, violence in Kiev forced President Yanukovych to flee to Russia. As the month drew to a close, Russia ignored US warnings and approved military action to protect its interests in the Crimea. The situation poses a significant geopolitical risk to markets in early March.

·   The Bank of Canada announces its policy rate decision on March 5 and is likely to restate that the direction of the next rate move will depend on uncertain growth and inflation developments. The Canadian economy grew at a solid 2.9% pace in 4Q13, but mix of growth was unfavorable with weak domestic demand and inventories making a large contribution to growth. In addition, December GDP fell by a larger-than-expected 0.5%, raising the odds of a sharp drop in growth in 1Q14.

·   Over the past month, US economic data have been weak, but much of the weakness has been shrugged off by markets as merely weather related and, therefore, temporary. However, some of the weakness probably reflects payback for a surge in activity in late 2013 and unusually cold weather continued right through January and February. It is quite possible the economic data will remain weak right through March. The optimism about a rebound in global manufacturing activity has dimmed.

·   Concerns about falling global inflation continued, with the G20 meeting backing away from austerity and calling for policies to boost growth and return inflation to target. Recent global inflation readings have been a bit firmer, but disinflation concerns remain and will grow if the soft growth data persist.

·   Despite some recovery in February, emerging markets remain a focus in financial markets. Financial conditions have tightened meaningfully in EM countries and very sharply in countries like Turkey and Brazil. China's growth continues to slow as the People's Bank of China attempts to slow runaway credit growth and the housing market shows signs of cooling. 

In a mid-January post on Inflation and Deflation Scenarios, I pointed to Russell Napier’s advice to watch inflation expectations (measured by US 5-year TIPs break-evens), copper prices and credit spreads. Since that post, these indicators have moved modestly, but not decisively, toward the outcomes consistent with the deflation scenario. The continued rally in sovereign bonds reflects a combination of weak growth, weak inflation and geopolitical risk. 

Last month, I concluded that, “If US equities, which broke key support levels on February 3, do not rebound to finish higher this week, raising cash will continue to be a good strategy.”

As it turned out, the equity market did rebound by the end of the first week of February to hold support and subsequently rose with theS&P500 setting a new record high on February 28. The rebound reflects a view that recent signs of economic weakness will melt away with the return of more normal weather this spring. China’s credit bubble and political instability in Ukraine remain as downside risks to the global outlook. January’s equity market correction reduced the excessive optimism that prevailed in early January, but equity valuations remain just as stretched now as they did then.

In mid-February, we put a little cash to work in US$ denominated EM bonds (EMB), as EM sovereign US dollar debt spreads became more attractive. However, we continue to favor a relatively cautious stance. Until we have more clarity on geopolitical risks and the trend of global growth and until disinflationary pressures show signs of abating, the direction of markets in 2014 remains highly uncertain. Having ample cash in the portfolio remains a good strategy, as opportunities to buy either equities or bonds at significantly lower levels later this year still seems like a good bet.