Atrocious?: Canada's economy in 1Q15

"The first quarter of 2015 will look atrocious, because the oil shock is a big deal for us".

That's what Bank of Canada Governor Stephen Poloz told the Financial Times in an interview on March 30. Since then, quite predictably, Canadian economists and financial journalists have been debating the meaning of the word atrocious. 

One observer cited Merriam Webster’s online dictionary definition of the word atrocious as “of very poor quality …  appalling … horrifying”. Most economists who have weighed in on the debate have argued that the 1Q15 economic data seen so far does not meet the definition. In spite of that, these same economists, after being shocked by the BoC's January rate cut, have been busy revising down their growth and inflation forecasts. 

So How Bad Is It?

Most of the sound bites in this debate have been reactions to individual economic releases. For example, real GDP declined by just 0.1% in January and economists judged that to be weak but not atrocious. The economy added 29,000 jobs in March and, while the jobs were all part-time, that didn't look atrocious. But these data points give a very incomplete picture of how the economy performed in 1Q15. A preliminary estimate of real GDP for the quarter won't be published by Statistics Canada until May 29, so we must judge the quarter so far by a wide range of monthly economic indicators, the same indicators that the Bank of Canada will utilize to update its economic projections to be released in the Monetary Policy Report on April 15.

The first place to look is at the source of the shock: the decline in the price of crude oil.

OK, that's atrocious! The price of energy commodities produced in Canada fell 53% from June 2014 to March 2015 with the bulk of the decline occurring in the December to March period. So what is the direct impact? First, lets look at Canadian energy exports, which account for about half of Canada's total exports.

In the three months to February, the value of energy exports fell 22% (or 63% at annual rates). That's atrocious! The plunge in energy exports pulled down the value of total exports by 1.6% (or 6.2% ar) over the same period. That's weak, but not atrocious. In volume (or real) terms, total exports are on track to be down 1.2% ar in 1Q15, after falling 3.0% in 4Q14. Soft, but not atrocious. While the value of energy exports has collapsed, the impact on total exports has been negative but not disastrous.

The next place to look is business investment. Governor Poloz told the FT that capital expenditures could fall by as much as 10% as a result of energy companies cutting back on investment. The energy sector has been the leader in rising business nonresidential investment in Canada in recent years. While there is little direct evidence on business investment in 1Q15, the Bank of Canada's Business Outlook Survey shows a weakening in investment plans.

The balance of opinion on machinery and equipment investment spending has fallen sharply in response to the plunge in the price of crude oil. The balance, at +4 in 1Q15, was the weakest since the recession of 2008-09. The Business Outlook Survey noted,

Weakness in investment intentions was concentrated in the goods sector and among firms that reported being adversely affected by lower oil prices ... Although firms outside the energy sector report that the outlook for U.S. growth and a weaker Canadian dollar are generally favourable for them, the positive impact on their investment intentions is taking time to materialize.

Machinery and equipment investment is only part of the business investment picture. Non-residential construction is another important component. Here once again, we have little direct evidence, but we can look at building permits. The value of permits for non-residential construction in the first two months of 2015 were down 22% (or -63% annual rate) from the fourth quarter level. Now that's atrocious!

Let's turn to residential construction sector. Many observers have noted that while housing activity remains strong in central Canada, the impact of lower oil prices is weighing on the the residential real estate market in Alberta and other energy producing regions. Housing prices are still rising in Toronto and Vancouver, but are falling in Calgary and Edmonton. But what about residential building permits and housing starts. The value of residential permits in the first two months of 2015 were down 7% (or -25% annual rate) from the fourth quarter level. That's verging on atrocious. And housing starts were also down sharply. Single-family housing starts fell 10% (or -35% ar) while multiple unit dwelling starts fell a more moderate 2.4% (or 9%ar).

What about consumer spending, which was supposed to benefit from lower gasoline prices. Real retail sales fell 1.2% in both December and January, which puts sales volumes on track for a 7% decline at annual rates for 1Q15. That's very weak! We could be surprised by a retail sales rebound in February-March, but I doubt it. More likely sales fell further in February and posted a modest rebound in March.

Another sector that should benefit from lower oil prices is manufacturing. Real manufacturing sales fell 3.2% ar in 4Q14 and were down 1.0% in January. But the interesting manufacturing data that we have is the Markit/RBC Manufacturing Purchasing Manager's Index (PMI), shown in the chart below:



The PMI, a diffusion index, fell below 50 in February and March, posting its lowest readings since its inception in late 2010. Although it does not have a long history, it correlates relatively well with the rolling 3-month annualized growth rate of Canada's real GDP, shown by the blue line in the chart. It suggests that further weakening of real GDP growth in 1Q15, to somewhere in the -1% to +1% range.

But what about employment and those 29,000 jobs in March? As mentioned, the economy actually lost 28,000 full time jobs and added 57,000 part-time jobs. Total hours worked, a better measure of labour input barely grew at all in 1Q15, rising just 0.3% ar, in line with very weak growth or even a modest decline in real GDP.

Was the Atrocious Comment Justified?

On balance, I would say yes, the plunge in crude oil prices did have an atrocious impact on 1Q15 growth. The data on 1Q15 that we currently have in hand is mixed between soft, very weak, and atrocious. In my opinion, it is weak enough to justify a further downgrade in the Bank of Canada's projection for real GDP growth in the April 15 Monetary Policy Report. In this sense, the comment was justified, albeit somewhat bold.

Is it weak enough to justify another 25 basis point cut in the policy rate to 0.50%. In my opinion, yes it is. Some observers believe that 2Q15 will post a meaningful rebound in growth. With the price of oil still barely above $50/bbl, I don't see why a strong rebound should be expected.

Poloz has taken a lot of criticism for surprising economists and markets with the rate cut in January. However, the negative impact of the oil price plunge on the Canadian economy is being borne out by the data. If the BoC cuts the policy rate again on April 15, his critics won't be able to say that he didn't warn them.

The Big No and The Big Mo

In a March 27 speech, Fed Chair Janet Yellen focused on what I call "The Big No" -- policy rate normalization. The Fed has spelled out what it means by the Big No as follows:

Specifically, monetary policy normalization refers to steps to raise the federal funds rate and other short-term interest rates to more normal levels and to reduce the size of the Federal Reserve’s securities holdings and to return them mostly to Treasury securities, so as to promote the Federal Reserve’s statutory mandate of maximum employment and price stability.

In short, this is the process of unwinding the Fed's emergency policies of ZIRP (zero interest rate policy) and QE (quantitative easing).

The premise of this post is that the Big No will bring to an end what I call "The Big Mo" -- the momentum trade that has seen the steady rise in the valuations of risk assets that has accompanied the use of unconventional monetary policies.

Yellen and the Big No

Fed Chair Janet Yellen's speech on March 27, "Normalizing Monetary Policy: Prospects and Perspectives", laid out the FOMC's views on policy rate normalization following the March Fed meeting. The Summary of Economic Projection (SEP) provided by FOMC members suggested that as the economy continues to improve and move toward meeting the Fed's dual mandate of maximum employment and price stability, the Fed Funds rate will move up as shown in the chart below.

The blue line in the chart shows the median expected path of the Fed Funds rate derived from the projections of the individual FOMC members (the so-called dot plot). The red line shows the minimum projection and the green line, the maximum projection. In outlining the Big No, Ms. Yellen made the following points:

• the FOMC's decisions will be data dependent; should incoming data fail to support [the SEP] forecast, then the actual path of policy will need to be adjusted appropriately;
• the level of the federal funds rate will be normalized only gradually;
• the FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the funds rate target range -- one that, for example, would involve similarly sized rate increases at every meeting or on some other schedule;
• the FOMC recognizes that many market participants assess the outlook quite differently. The Survey of Primary Dealers in late January thought there was a 20 percent probability that, after liftoff, the funds rate would fall back to zero sometime at or before late 2017.
• there are risks to moving either too slowly or too quickly.

The median path projects that the Fed Funds rate will follow a smooth path, rising to 3.25% by the end of 2017. The most optimistic FOMC member projected a rate of 4% by the end of 2017, while the least optimistic projected a rate of 2%. Any one of these scenarios would be a sharp break after six years of the policy rate being pinned down at close to zero.

Can the economy and markets handle a move in the funds rate along the median path? Some are not so sure. Ray Dalio of Bridgewater Associates warned against a 1937 style policy mistake and cautioned the Fed this way:

We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart. What we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.

Christine Lagarde of the IMF warned of emerging markets instability as the Fed normalizes monetary policy. The staff of the BIS has warned that given the massive rise in US dollar credit since the Fed launched it unconventional monetary policy, US rate hikes pose a major threat to global financial stability (see here and here).  

The Big Mo

 
Since the Fed began the pursuit of unconventional monetary policy, asset valuations have risen steadily and volatility in financial markets has been suppressed by the low policy rate and regular injections of central bank liquidity. Using ETF total returns, the chart below shows the steady rise in valuations of US equities (SPY, the green line), government bonds (TLH, the yellow line) and high yield credit (HYG, the blue line).

Total Returns (including all dividends)

Since the Fed went to ZIRP in December 2008, SPY has returned 163% (16.6% per annum), HYG has returned 123% (13.6% p.a.) and TLH has returned 42% (5.7% p.a). During this period, equity valuations, measured by Shiller's Cyclically Adjusted Price Earnings (CAPE) ratio have risen to highs exceeded only in the periods before the 1929 and 2000 market crashes. Bond yields have fallen to record lows, implying bond prices at record highs. And high yield credit spreads have fallen back to pre-GFC lows.

As long as markets could anticipate that the Fed would respond to any economic weakness by further easing of monetary policy, asset values continued to rise. Market participants have been paid to stick with the momentum trade -- the Big Mo: long equities, long duration, and long credit.

When the Big No begins, the Big Mo ends

In May 2013, former Fed Chair Bernanke spooked markets by indicating that the Fed would begin to taper its quantitative easing program. Equities, bonds and high yield credit markets all experienced a correction and a rise in volatility -- a "taper tantrum" -- that lasted a few weeks for equities and credit and a few months for bonds. In August 2014, Fed Chair Yellen gave a speech at Jackson Hole that laid the groundwork for the Fed to begin the discussion of policy rate normalization. Once again, equities, bonds and high yield credit markets experienced corrections lasting three to six weeks.

With the March 2015 FOMC meeting and Yellen's March 27 speech, the Fed indicated that it expects to begin policy rate normalization later this year, possibly as early as June, and laid out a range of scenarios for the expected policy tightening path. In the wake of this decision, the momentum trade -- the Big Mo -- has shown early signs of breaking down again. 

So here is the new counter-intuitive conundrum for investors as the Fed moves toward the Big No: sustained solid improvement in the US economy is likely to be bad for all three asset classes that benefitted in the Big Mo trade: equities, bonds and high yield credit.

For the Big Mo trade to continue to perform, growth will need to stay mediocre and inflation will need to remain below target. This type of economic outcome will push back policy rate normalization and keep highly accommodative monetary policy in place.

That's why the disappointing US employment report for March on Good Friday saw stocks and high yield credit rally when markets reopened on Monday. The soft employment report pushed back the market's assessment of the timing of the beginning of the Big No to September from June.    

Global ETF Portfolios: 1Q15 Review and Outlook

Global ETF portfolios for Canadian investors continued their stellar performance in the first quarter of 2015. Most of the strong performance was attributable to a further 8.4% depreciation of the Canadian dollar relative to the USD that provided a profitable tailwind for Canadian investors in USD denominated global ETFs.

Global economic developments were, once again, disappointing:

• Global growth and global inflation were both significantly weaker than expected in 1Q15.   
• Nine of the eleven large economies that I track have had their 2015 growth forecasts revised down since the beginning of the year. The exceptions are the Eurozone, where the growth forecast has barely edged up, and India, which has been a legitimate positive surprise. Russia and Brazil are contracting. China is slowing, probably by more than the official statistics.
• Nine of the eleven large economies that I track have had their 2015 inflation forecasts revised down. The exceptions are Brazil and Russia, where large exchange rate depreciations are pushing inflation higher.
• Led by crude oil, commodity prices continued to decline in 1Q15, putting further downward pressure on the currencies of commodity exporting countries, including Canada.
• Global central bank policies diverged. The US Fed continued to prepare markets for an increase in the policy rate in 2015. The BoJ pursued and the ECB initiated aggressive quantitative easing. Other central banks, including the BoC and the PBoC, responded to weakening growth, plunging oil prices and falling inflation by cutting their policy rates. Russia and Brazil were forced to hike policy rates to support their currencies. 
• The USD appreciated against virtually all global currencies.
• Bond yields fell virtually everywhere, again with the exception of the distressed economies.

From my perspective, a key development for markets was that, despite much weaker than expected US economic growth and inflation in 1Q15, the Fed continued to stress the need for "policy normalization". At the March FOMC meeting, the Fed dropped the use of the word "patience" form its policy guidance and Fed Chair Janet Yellen indicated that this meant that the policy rate would likely rise later in 2015. Importantly, the Fed signalled that the normalization of rates would be gradual and dependent on incoming economic data. This note of caution took some of the steam out of the US dollar appreciation, but only pushed back analysts expectations of the timing of the first rate hike by a few months at most.

For its part, the Bank of Canada surprised most observers by cutting its policy rate by 25 basis points to 0.75% in January. The Canadian dollar (CAD) depreciation versus the USD accelerated following the BoC move. Many observers criticized the BoC for not signalling the rate cut more clearly, but as the quarter ended, it appeared that the BoC's concerns, that the plunge in crude oil prices would produce a sharp negative shock to both growth and inflation, were well founded.

Global Market ETFs: Performance for 1Q15

In 1Q15, with the USD appreciating 9.2% against the CAD, the best global ETF returns for Canadian investors were in Japanese and Eurozone equity ETFs. Despite the weakening of their currencies, the two equity markets where central banks pursued the most aggressive monetary stimulus posted the strongest global returns. The worst returns were in commodities. The chart below shows 1Q15 returns, including reinvested dividends, for the ETFs tracked in this blog, in both local currency terms (i.e. USD terms for the global ETFs) and in CAD terms.

In local currency terms, 14 of the 19 ETFs posted positive returns, while 5 ETFs posted losses. In CAD terms, 18 of 19 ETFs posted gains, while just 1 posted a loss.

The best gains were in the Japanese equity ETF (EWJ) which returned a stunning 21.7% in CAD. The Eurozone equity ETF (FEZ) was second best, returning 15.0% in CAD. Other strong gainers included US Small Cap equities (IWM), which returned 13.5% in CAD; USD-denominated Emerging Market bonds (EMB) 12.3%; US Long Bonds (TLH) 12.3%; US Investment Grade bonds (LQD) 11.9%; Emerging Market equities (EEM) 11.5%; US High Yield bonds (HYG) 11.3%; US Inflation-linked bonds (TIP) 10.7%; and US Large Cap equities (SPY) 10.1%.

Canadian assets underperformed global ETFs in 1Q15. The Long Bond ETF (XLB) returned 7.2%; the Real Return bond (XRB) 6.6%; the Corporate bond (XCB) 3.2%; and Canadian equities (XIU) 2.7%. 

The worst performer, by far, was the commodity ETF (GSG), which returned -1.4% in CAD. The Gold ETF (GLD) fared better with a virtually zero return in USD but a 9.2% return in CAD terms.

Global ETF Portfolio Performance for 1Q15

In 1Q15, the Canadian ETF portfolios tracked in this blog posted strong returns in CAD terms when USD currency exposure was left unhedged, but only moderate returns when USD exposure was hedged. In a November post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 8.1% in CAD when USD exposure was left unhedged, but just 3.4% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 6.3% if unhedged, but just 1.7% if USD hedged.

Risk balanced portfolios outperformed in 1Q15, continuing the trend established in 2014. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 12.1% in CAD terms if USD-unhedged, but had a less stellar gain of 2.6% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 8.3% if USD-unhedged, but just 1.5% if USD-hedged.

Recent Performance in Perspective

The robust performance, in Canadian dollar terms, of the unhedged global ETF portfolios has been driven largely by the strength of the USD versus CAD.

The twin causes of the CAD weakness have been the plunge in commodity prices, led by crude oil which is Canada's largest export, and the divergence and Fed and BoC policy. It is an interesting question as to whether these trends will continue.

Crude oil inventories are at record levels and oil production continues to run ahead of demand. Many analysts expect crude oil prices to fall further in 2Q15.

Fed and BoC policy divergence has accelerated the weakening of CAD. In both countries, 1Q15 growth and inflation have fallen short of expectations. While the Fed has so far remained steadfast that policy rate normalization will begin later this year, the BoC has responded to a huge negative terms of trade shock (appropriately in my view) by cutting its policy rate. The US economy appears better positioned than Canada for a 2Q15 rebound, but the soft US employment report for March suggests caution. If growth disappoints in both countries as 2Q unfolds, however, it is likely that the Fed response will just be to delay tightening, while the BoC response will be to cut rates again.

In this environment, maintaining unhedged exposure to global ETFs remains my preferred portfolio stance.   

While the more conservative 45/25/30 portfolio (which I have favoured) under performed the more aggressive ETF portfolios, we can hardly be dissatisfied with a year-to-date return of 6.3%. As we enter 2Q15 in a continuing uncertain environment, characterized by significant global divergences in growth and central bank policies, and with rich valuations for both US equities and bonds, remaining well diversified with an ample cash position continues to be a prudent strategy.