In May and June of 2013, we had the "Taper Tantrum" in markets, sparked by then-Fed Chair Ben Bernanke's announcement that the Fed would begin to taper its $US85 billion per month quantitative easing (QE) program. Over a four week period from May 24 to June 21, 2013, returns on all major asset classes fell as markets adjusted to the expectation that large-scale Fed purchases of US Treasuries and Mortgage Backed Securities would end. With all asset classes posting negative returns, all types of portfolios experienced losses, but some portfolios lost much more than others.
In September 2014, we are experiencing the sequel to the Taper Tantrum, which I will call Exit Ennui. This sequel was triggered, I believe, by Fed Chair Janet Yellen's speech at Jackson Hole. There was nothing wrong with the speech. It was surprisingly balanced. While Yellen is widely perceived as occupying a position near the dovish extreme on the Hawk-Dove spectrum among FOMC members, she did not make a dovish speech at Jackson Hole. That was left for ECB President Mario Draghi and the main result was to highlight the divergence in economic performance between the world's two largest economies: US relative strength versus Eurozone relative weakness.
In the weeks since Jackson Hole, US economic data has retained a strongish bias and attention has focussed on when the Fed will begin to raise official interest rates and what form the exit strategy will take. In the wake of Yellen's Jackson Hole speech the 10-year US Treasury yield moved up from 2.34% on August 27 to 2.62% on September 16, ahead of the Fed decision on September 17.
In the chart below, I compare returns on the ETFs that I regularly track during the Taper Tantrum with those seen to date (as of September 22) in the Exit Ennui. The returns are in Canadian dollar (CAD) terms and it is interesting to note that during the first four weeks of the Taper Tantrum, the CAD weakened 1.3% versus the USD, while in the Exit Ennui it has weakened a very comparable 1.4%.
Based upon this chart, we can make the following observations:
- The Exit Ennui has not yet done as much damage as occurred during the first four weeks of the Taper Tantrum.
- In both periods, all asset classes performed relatively poorly. Nominal bonds, inflation-linked bonds, credit, equities and commodities all sold off to varying degrees.
- Inflation-linked bonds were relatively hard hit in both periods.
- Emerging Market assets have fared relatively better in the Exit Ennui than they did in the Taper Tantrum.
- Long-duration bonds performed relatively poorly in both episodes.
- Commodities have performed worse in the Exit Ennui than in the Taper Tantrum
- Within equities, Canadian equities performed relatively poorly in both episodes
Portfolio choices make a big difference during drawdown periods like the Taper Tantrum and the Exit Ennui. The chart below shows the performance of the four portfolios that I regularly track.
The traditional Canadian 60% Equity/40% Bond ETF Portfolio, which lost 3.44% during the Taper Tantrum is down just 63 basis points so far in the Exit Ennui as equities have not been hit as hard this time around. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, which lost just 2.11% in the Taper Tantrum is down 56 basis points in the Exit Ennui.
Risk balanced portfolios posted larger losses in both periods. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 7.03% in the Taper Tantrum and is down 2.42% so far in the Exit Ennui. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, lost 4.13% in the Taper Tantrum and is down 1.10% so far in the Exit Ennui.
What this highlights, is that leverage has not been an investor's friend during periods in which markets are pricing in reduced Fed monetary accommodation. During these drawdown periods, cash is often the best asset class, which is why the 45/25/30 portfolio tends to perform best during these episodes.
In a recent post, I reviewed the evidence on equity valuations and concluded that, according to the most credible metrics, US equities are close to the richest valuations on record. But it is not only equities that are expensive. Government bonds are expensive. Corporate bonds are expensive, especially high yield or junk bonds. Real estate is expensive. In short, most asset classes are expensive. This means that, while one cannot confidently forecast short-term asset class returns, one can be fairly confident that long-term returns on these asset classes will be quite low relative to recent history.
This note discusses the two main reasons why markets are so richly priced. It examines the role of central bank policies and corporate management behavior in bidding up asset prices. When central bank policies and/or corporate behavior change, asset prices will likely move, either gradually or suddenly, toward fair value. The period of transition will be a nervous one for investors.
The Role of Central Banks
Central banks have played a central role in enriching asset prices since the Great Financial Crisis (GFC). As the GFC unfolded, major central banks cut their policy rates to close to zero and, because they felt that this did not provide sufficient stimulus, resorted to various forms of quantitative easing (QE). QE involves the large-scale purchase of government bonds or private assets such as mortgage-backed securities. As central banks engage in such purchases, the size of their balance sheets expands. The charts below, from a recent report by Nikolaos Panigirtzoglou of JPMorgan, show the growth in the size of the balance sheets of the US Fed, Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) in the left hand chart and the combined expansion in US$ of the four central bank balance sheets on the right. The result has been that the total balance sheet of the four big central banks expanded from $US 4 trillion in 2008 to almost $US 11 trillion by the end of August, 2014.
By cutting their policy rates to close to zero and providing forward guidance that policy rates would stay exceptionally low for an extended period of time, the central banks have encouraged investors reduce their holdings of cash and to take more risk. Investors have responded by bidding up prices of equities, commodities, government bonds, corporate bonds, real estate and infrastructure assets. By undertaking QE, central banks have provided the liquidity to support investor's risk-taking.
The result is that many equity markets are richly-valued, while government bond yields have fallen back toward post-GFC lows more than five years into the tepid global recovery. Corporate and emerging market bond yield spreads over US Treasuries are near their pre-GFC lows. Real estate prices in many countries are at record highs. As Panigirtzoglou argues, "Asset yields are mean reverting over long periods of time and thus historically low levels of yields in bonds equities and real estate are unlikely to be sustained forever."
Corporate Behavior and the Bonus Culture
The second, but much less discussed source of overvaluation of asset prices is corporate behavior, specifically what is known as the “bonus culture”. Andrew Smithers has developed the most insightful analysis of this change in corporate behavior brought about by changes in the way that management is compensated.
As Smithers explains in his new book, The Road to Recovery, the shift in executive compensation systems over the past two decades to rely heavily on bonuses combined with changes in corporate accounting rules have increased both management’s incentive and ability to overstate corporate profits. This means that profits are regularly overstated in good times and then understated through write-offs during bad times.
The change in accounting rules that made this possible was the change from “marked to cost” to “marked to market”. With marked to market accounting, changes in asset prices, either positive or negative, make a greater contribution to reported corporate profits and thereby make profits much more volatile. This is good for corporate managers because, as Smithers points out:
As bonuses usually depend on changes in profits, companies’ managements will usually be able to benefit from both over- and understated profits. When profits are overstated, they will rise more than they otherwise would have done and bonuses will rise with them. When profits are understated in one year but not the next, the rise in profits will also be exaggerated, together with the associated bonuses. Managements therefore want profits to be volatile. As management gets what management wants and what management wants has been greatly eased by marked to market accounting, the result has been the growth of periodic write-offs.
Assets are therefore periodically written up or written down. The associated write-offs are either an admission that profits have been overstated in the past or a promise that management will try to overstate them in the future.
Smithers also explains how the bonus culture leads corporate management to favor buying back corporate equity over investing in new capital equipment and software. Equity buy-backs increase earnings per share in the short term, while investment in capital equipment reduces earnings per share over the same period. Increasing earnings per share increases management bonuses and so is the more attractive choice.
Stock buybacks are a major cause of equity overvaluation. The chart below, from a recent article by Henry Blodgett posted on Business Insider, shows that in Q1 of this year “equity buybacks hit almost the highest level in history -- exceeded only by a couple of quarters in 2007, just before the market tanked”.
By Blodgett’s calculation, stock buybacks, which reached US$159 billion in 1Q14, have outstripped new share issuance for several years and, as a consequence, the total number of shares outstanding for S&P500 companies is now lower than it was in 2005. Share buybacks have been financed by corporate cash flows, which have been waning recently, and by issuance of debt which has levered up corporate America.
What will end the Overvaluation?
The two main drivers of asset overvaluation are central bank policies, (specifically near-zero policy rates and large-scale QE) and corporate behavior (specifically overstatement of profits and equity buy-backs). Overvaluation will likely diminish, perhaps rapidly, when these policies and behavior change.
Quantitative easing by the Fed is set to end in October and the policy rate is expected to begin to rise some time in the first half of 2015. On previous occasions when the Fed has attempted to end QE, equities have weakened and bond yields have fallen as investors feared that the economy would slump as monetary stimulus was reduced. However, in this instance, US growth appears to be accelerating, the economy is operating closer to full capacity, and the Fed is expected to follow up termination of QE with an increase in the policy rate. If the growth acceleration continues and inflation remains stable, the US Treasury bond market is likely to sell off. If the growth acceleration continues and inflation moves above target, all asset markets are likely to weaken. A potential mitigating factor is that the ECB may be preparing a new round of large scale QE, but this might just add to volatility in foreign exchange and other markets.
Stock buy-backs are likely to continue as long as corporate cash flows remain solid and bond investors remain willing to buy corporate debt at relatively narrow spreads over government bonds. However, there are signs that cash flow growth has peaked and that investors are becoming wary of corporate credit. Should corporate profits and cash flows be squeezed by the faster wage growth that Fed Chair Janet Yellen wants to see, the massive flows into high yield and investment grade corporate debt driven by investors search for yield could reverse. Strategists have pointed out recently that regulation has reduced the willingness and ability of bank-owned dealers to make liquid markets in corporate debt. Should investors decide to significantly reduce their corporate debt holdings, not only would credit markets suffer potentially serious losses, but a major source of funding for equity buy-backs could dry up.
It is, therefore, for good reason that the Fed and the Bank of England are likely to move toward tightening policy with great caution. Beginning the process of reversing years of extreme monetary ease could prove quite unsettling to richly-valued financial markets.
Global markets provided solid returns in August as geopolitical risk seemed to ebb through mid-August, and Mario Draghi stole the show at the central bankers’ confab at Jackson Hole by hinting at further ECB monetary stimulus. For Canadian investors with currency-unhedged portfolios of global ETFs, it was another highly profitable month. Significant market and global macro developments in August included:
- Global equity ETFs were mostly higher. US, Emerging Market, and Canadian equity ETFs posted solid gains, while Eurozone equities were flat and Japanese stocks were down.
- US and Canadian government bond ETFs posted strong gains, while European and Emerging Market Local Currency bonds performed relatively poorly as their currencies weakened.
- The US dollar strengthened against most major currencies.
- Gold stabilized but the commodity ETF posted a second consecutive sharp monthly loss.
- Energy prices weakened as the WTI crude oil futures price fell to $96/bbl at the end of August.
- US and Canadian GDP growth posted better than expected 2Q rebounds but Europe and Japan reported much weaker than expected 2Q growth.
- Global inflation moderated in July after picking up in May-June, with Eurozone inflation falling to just 0.3%.
- The Jackson Hole meeting of central bankers underscored the divergent paths of central banks, with the US Fed and BoE preparing rein in monetary stimulus while the ECB and BoJ are under pressure to increase stimulus. The Bank of Canada prefers to remain neutral as to whether its next policy move will be a tightening or an easing.
Global Market ETFs: Monthly Performance for August
The S&P500 closed August at a record-high 2003, up from 1931 at the end of July and 1960 at the end of June. Global equity ETFs were mostly higher in August. Despite a sharp weakening in early August after an erroneous employment report, the C$ closed August with a gain of 0.2% vs. USD, slightly moderating Canadian dollar returns on USD denominated ETFs. US Small Cap stocks (IWM) were the top performers among the equity ETFs we track, gaining 6.7% in CAD terms. US Large Cap stocks (SPY) returned 3.7%, Emerging Market equities (EEM) returned 2.6%, and Canadian equities returned 1.6%. Eurozone equities (FEZ) were flat in August in CAD terms. The worst performers were Japanese equities (EWJ), which returned -1.9% in CAD terms.
Commodity ETFs were mixed. The Gold ETF (GLD) returned 0.3% in CAD terms, while the GSCI commodity ETF (GSG) returned -1.8%.
Global bond ETFs posted mixed returns. ETFs with positive returns in August included the US long government bond (TLH), which returned 2.4%, Canadian Long Government bonds (XLB), which posted a 2.3% return, and USD-denominated Emerging Market bonds (EMB) and EM Local Currency Bonds (EMLC), which returned 1.0% and 0.1% in CAD terms, respectively. Non-US government bonds (BWX) were flat in CAD terms, as weakness in the Euro and widening spreads on some Eurozone periphery bonds offset gains in Germany in other markets.
Inflation-linked bonds (ILBs) posted more modest positive returns in August as global inflation moderated. Canadian RRBs (XRB) returned 0.7%, while US TIPs (TIP) returned 0.4% in CAD terms. Non-US ILBs (WIP) returned 0.7%.
Corporate bonds performed well in August as US investment grade (LQD) and high yield (HYG) bonds returned 1.8% and 2.1% respectively, in CAD terms. Canadian corporate bonds (XCB) returned 0.8%.
Year-to-date Performance through August
In the first eight months of 2014, with the Canadian dollar depreciating 2.4% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in Canadian equities (XIU), Canadian inflation linked bonds (XRB), and US long term bonds (TLH). The worst returns were in Japanese equities (EWJ) and commodities (GSG). It seems unusual, and perhaps unsustainable, that Canadian equities are world-beaters in a year in which commodity ETFs have been among the worst performers.
In global equities, the Canadian equity ETF (XIU) performed best, returning 16.6% year-to-date (ytd). The S&P500 ETF (SPY), which hit a record high, returned 7.7% in CAD terms. Emerging Market equities (EEM), after a rough start to the year, rebounded to return 11.1% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, suffered from geopolitical tensions and currency weakness in June through August and returned 1.3% ytd in CAD terms. The Japanese equity ETF (EWJ), after losses in August, returned just 0.1% ytd in CAD terms. US small caps (IWM), after rebounding in August, returned 7.5% ytd in CAD terms.
Commodity ETFs had lackluster performances this summer after strong starts to the year, dragging down year-to-date returns. The Gold ETF (GLD) has returned 9.2% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned just 0.1%.
Global Bond ETFs continued to perform extremely well for Canadian investors. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, safe haven demand, and accommodative central bank policies. The US long bond ETF (TLH) returned 13.3% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of +11.6% ytd. USD-denominated Emerging Market bonds (EMB) returned 11.1% ytd in CAD terms. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 7.1% in CAD terms. Non-US global government bonds (BWX) posted a return of 7.0% ytd.
Inflation-linked bonds (ILBs) continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has fared best, benefiting from its long duration, returning 13.5% ytd. Non-US ILBs (WIP) returned 10.5% in CAD terms, while US TIPs (TIP) returned 8.4%.
In corporate bonds, the US investment grade bond ETF (LQD) returned 10.2% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 7.2% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 5.2%.
Global ETF Portfolio Performance through August
In August, the Global ETF portfolios tracked in this blog posted strong gains, adding to positive year-to-date returns, which has been aided by the weakness of the Canadian dollar.
The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 154 basis points in August to be up 9.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 181 bps to be up 8.6% ytd.
Risk balanced portfolios also posted robust gains. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 240 bps in August, boosting to its year-to-date gain to 15.4%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 183 bps in August to be up 10.1% ytd.
Outlook for September
The Ukraine crisis, which seemed to stabilize through August as Ukrainian forces pushed back Russian supported rebels. But in the final days of the month, NATO reported that Russian tanks and troops crossed the Ukrainian border, taking hostilities to a new level and likely triggering a new round of sanctions on Russia. Conflict continued in Iraq, with the US launching air strikes against ISIS. Geopolitical risks, which appeared to be waning through much of August, really did not.
Key developments that Canadian ETF investors should be watching in September include:
- US labor market developments will remain a key focus because that is what Fed Chair Yellen is watching. A strong August employment report on September 5, especially if it provides evidence that wages are accelerating could add to speculation that the Fed will have to raise the policy rate sooner tan currently expected.
- US dollar strength will continue to be fueled by safe haven flows (as NATO tries to counter Russia incursions into Ukraine and the US contemplates air strikes on ISIS in Syria), and by the divergent monetary policy paths being taken by the Fed and the ECB toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.
- The Bank of Canada’s policy rate decision on September 3, when the BoC will react to solid 2Q real GDP growth of 3.1%, an upward revised July employment report, and inflation moving closer to the 2% target. I expect that the BoC will continue to find reasons to remain neutral on the direction of the next policy rate move. Further weakening of the Canadian dollar will be tolerated.
- The debate between US equity bulls who favor buying every dip and those advising caution due to high equity valuations (see here) will continue. The S&P500 had its best August in 14 years, according to CNBC. Ironically, that takes us back to August 2000, the peak of the Tech Bubble.
- Concerns about global inflation are more balanced than earlier this year. Inflation has accelerated somewhat in the US, UK, Japan and Canada, but decelerated toward deflation in the Eurozone. The risk of a global deflationary shock still seems much greater than the risk of an inflationary shock.
In recent monthly reviews, I have concluded that, “Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.”
As it turned out, the ample cash dampened returns in my desired portfolio in July and August, but returns were still quite acceptable. The unstable equilibrium that has allowed equity prices to drift steadily higher this year could persist for months or it could come to a volatile and sudden end. Prudence leads me to continue to favor an ample 30% cash allocation as we await the denouement.
