Just a quick update to indicate that, in my opinion, the Bank of Canada's 25 basis point rate cut to 0.50% was quite appropriate.
I had recommended that the BoC cut to 0.50% as early as last March and again recently when the C.D. Howe Monetary Policy Council met last week.
Why do I think it was appropriate? To update the analysis from my recent post titled "Equilibrium Real Policy Rates: Does Anybody Really Know", the Taylor Rule for the appropriate policy rate, as cited recently by Fed Chair Janet Yellen is:
The current policy rate (R) should = the equilibrium real policy rate (RR*) + core inflation (π) + 0.5 * the gap between current inflation and target inflation (π - π*) + 0.5 * output gap (y).
Today's Monetary Policy Report provided the inputs required to calculate the appropriate policy rate. Using assumptions, along the lines of those used by Ms. Yellen, that the equilibrium real policy rate is close to 0% currently; that the underlying trend in inflation is assessed to be 1.5 to 1.7% (p. 15) and that the Canadian output gap is -2.2% (p. 20), the current policy rate should be 0.30% or (0 + 1.6 - 0.2 - 1.1), or slightly lower than the 0.5% that the Bank of Canada set today.
With the economy clearly in a marked slowdown and with a federal election looming in October, the Bank of Canada was wise to take out additional insurance to bolster the economy now. If growth recovers strongly later this year, the BoC may eventually be in a position to reverse the quite appropriate easing that has been provided since January.
Economic forecasting is easy. Anyone can fill in a spreadsheet with their best guesses of how GDP growth, inflation, and central bank policy rates will unfold and call it a forecast. There are no professional standards or guidelines that must be met to publish a forecast. An economist I once knew often said his goal in making forecasts was to be "100% memorable and 51% accurate".
Forecasting accurately is extremely difficult. This is partly because unexpected events or shocks are constantly buffeting economies. It is partly because economic data is published with some delay and is often significantly revised later, especially at cyclical turning points. This means that, at any point in time, even analysts who follow the economic data closely have an unclear picture of the current state of the economy which is the starting point for their forecasts. This makes it more difficult, even for the best analysts, to accurately foresee inflection points in growth and inflation.
As I have written elsewhere, another issue for forecasters is what is known as the "optimism bias". The optimism bias in economic forecasts is well documented and widespread. In a 2011 study for the US National Bureau of Economic Research, Jeffrey Frankel found that for 33 countries, on average, the upward bias in real GDP forecasts is 0.4% when looking one year ahead, 1.1% at the two-year horizon and 1.8% at three years. Despite Frankel's findings, forecasters retain their optimism bias. In recent years, this bias has had a seasonal component, with optimism seemingly peaking in December-January as year ahead forecasts are publicized. 2015 is proving no different.
The table below presents revisions in 2015 growth and inflation forecasts for the twelve economies that I regularly monitor in this blog.
Growth Forecast Revisions
The table compares forecasts made at the turn of the year with revised forecasts published last week by two of the very best global forecasting organizations, the International Monetary Fund (IMF) and JP Morgan Economics (JPM). For real GDP growth, there are substantial downward revisions across a wide range of countries. [Note that revisions to global growth are smaller, but this appears to be due to shifts in purchasing power parity (PPP) weights toward higher growth economies like China and India].
With all of the recent angst over Grexit and the bursting of China's stock market bubble, it is perhaps surprising that the largest downward growth revisions are not in Europe or Asia, but instead in the Western Hemisphere. The most significant downward revision is for the world's largest economy, the United States. The IMF has downgraded its' dizzying 3.6% forecast for US growth to 2.4%, while JPM has cut from 3.0% to 2.2%. The downgrade to US growth has cascaded through the hemisphere, with Mexico downgraded from robust to moderate growth, Canada downgraded from moderate growth to near-recession, and Brazil downgraded from virtually no growth to outright recession.
By comparison, growth downgrades are more moderate for Japan, the UK, Australia and Korea. There is a notable growth upgrades for India. Growth forecasts for the Eurozone and China are little changed, as is Russia's recession forecast.
This is where the optimism bias continues to rear its' head. Do forecasters really believe that the disappointments in Western Hemisphere are over and that the recent turmoil surrounding Greece and China will have no impact on Eurozone and Chinese growth? Could the turmoil be a harbinger of further problems within these large economies?
Inflation Forecast Revisions
Revisions to inflation forecasts are more mixed. The big change to factor into 2015 inflation forecasts has been the collapse in the price of crude oil over the past year. Most of the decline had occurred by early in 2015 and was being taken into account in turn of the year forecasts. These forecasts have been complicated by the effects of some large exchange rate movements.
On balance the largest downward revisions to end-2015 CPI inflation forecasts have been in the UK, Mexico, Australia and India. These downward revisions have been offset by large upward revisions to year-end inflation forecasts for Russia and Brazil, where exchange rate depreciation is pushing up inflation despite the economies being in recession.
There is no change in China's 2015 inflation forecast at 1.7%, despite inflation having averaged just 1.3% in the first six months of the year and despite clear signs that growth is slowing, that house prices are falling and that confidence has been shaken by the recent stock market crash.
Implications for Monetary Policy
The forecast revisions since the beginning of the year mainly reflect disappointment that overly optimistic growth forecasts have not been met. From a policy perspective, this has meant unexpected monetary policy easing in some countries and a delay in tightening policy in others. Among the economies monitored here, central banks of Canada, Australia, Korea, India and Russia have all provided policy rate cuts that were not expected at the beginning of the year, while Japan and the Eurozone have added to their QE bond purchase programs. The US and UK have delayed raising their policy rates.
Implications for Markets
In this environment of widespread downward revisions to growth forecasts, more moderate and mixed revisions to inflation forecasts and unexpected easing of monetary policy, asset markets have provided little gain and plenty of volatility. The chart below shows year-to-date ETF returns for the the major asset classes in both USD terms (green bars) and CAD terms (blue bars).
With the exception of Japanese equities (EWJ, which returned over 12%), USD returns on these ETFs have been weak, ranging from -8% for Canadian equities (XIU) to +4% for US Small Cap stocks (IWM). Of course, when a 9% appreciation of the USD vs CAD is factored in, Canadian dollar investors (who did not currency hedge) enjoyed positive returns on all of these ETFs.
Commodity returns were negative in USD terms. Eurozone (FEZ) and Emerging Market (EEM) equity returns were negative. Inflation-linked bond ETF returns were negative. Credit ETF (LQD and XCB) returns were negative in USD terms, with the exception of US High Yield (HYG). In Emerging Market bonds, those denominated in USD (EMB) had positive returns, but those denominated in local EM currencies had negative returns. US 10-year Treasury bonds (TLH) and non-US government bonds (BWX) also had negative returns in USD terms.
High Hopes Dashed, Uncertainty Remains
Hopes raised by the giddy economic forecasts made at the turn of the year have been dashed. Only those investors who played the currencies correctly have made any money this year; the underlying asset values have been eroded by disappointing growth, weak commodity prices, and fears that (sometimes desperate) monetary policy easing will be ineffective and/or ultimately reversed.
The biggest question mark for the remainder of the year is China. The bursting of the previously surging Chinese equity bubble has led the government to take unprecedented steps to stabilize the stock market that could yet backfire. A full-blown Chinese financial crisis would be devastating to still optimistic global growth and inflation forecasts.
Global ETF portfolios for Canadian investors gave back a lot of their first quarter gains in 2Q15. The weaker performance was partly attributable to a 1.6% appreciation of the Canadian dollar relative to the USD that reduced C$ returns for Canadian investors in USD denominated global ETFs.
Global economic developments were mixed but, once again, generally disappointing:
- The forecast for global growth in 2015 continued to be revised down.
- Global real GDP growth in 1Q15 fell to its weakest pace since the 2008-09 global recession. Four of the eleven large economies that I track contracted in 1Q15, including US, Canada, Brazil and Russia. The US is on track for a moderate growth rebound in 2Q15, but the other three economies are still contracting. Following decent starts to the year, Eurozone and Japan growth moderated in 2Q15.
- Crude oil prices stabilized and posted a modest recovery, supporting the currencies of oil exporting countries, including Canada.
- Inflation forecasts stabilized in 2Q15 as oil prices recovered and deflation worries eased.
- Despite the US Fed still signalling that it intends to begin raising the policy rate this year, global central banks continued to ease policy. China, Korea, Australia and Russia cut their policy rates in 2Q15. Brazil was again forced to hike policy rates to support its currency.
- After falling virtually everywhere in 1Q15, bond yields reversed course and rose virtually everywhere in 2Q.
- In the final weeks of 2Q, after surging into bubble territory, China's equity market entered a sharp correction, falling by over 20% from its highs.
- In the final days of 2Q, negotiations between Greece and its official creditors broke down and Greece defaulted on a 1.6 billion Euro payment to the IMF. As 3Q begins, with Greek banks closed, capital controls looming, and a referendum planned for July 6, the situation remains fluid.
Despite reduced growth prospects and below target inflation, the Fed continued to stress the need for "policy normalization". In late June, New York Fed President William Dudley said that a September rate hike is still very much in play. Importantly, the Fed continues to signal that the normalization of rates will be gradual and dependent on incoming economic data. This caution has taken some of the steam out of the US dollar appreciation.
The Bank of Canada failed to follow up on a January rate cut with additional easing, judging that the negative shock to growth and inflation from weaker crude oil prices was faster but not larger than anticipated. This judgement was challenged by the June 30 release of April real GDP data showing a fourth consecutive monthly decline and rekindling speculation that another easing move is needed. The Canadian dollar, which had firmed versus the USD on moderately higher crude oil prices, was weakening again as 2Q came to a close.
Global Market ETFs: Performance for 2Q15
In 2Q15, with crude oil prices recovering and the USD weakening 1.6% against the CAD, the best global ETF returns for Canadian investors were in commodity and Japanese equity ETFs. The worst returns, driven by rising bond yields, were in US government and investment grade corporate bonds and Eurozone equities. The chart below shows 2Q15 and year-to-date returns, including reinvested dividends, for the ETFs tracked in this blog, in CAD terms.
In CAD terms, 17 of 19 ETFs posted losses, while just 2 posted a gain.
The gains were in the commodity ETF (GSG), which returned 6.6%, and the Japanese equity ETF (EWJ), which returned 0.7% in CAD.
The worst losses were in US Investment Grade bonds (LQD) -5.6%; US 10-year Bonds (TLH) -5.1%; and the Eurozone equity ETF (FEZ) -5.1%.
Canadian ETFs performed poorly in 2Q15. The Long Bond ETF (XLB) returned -4.4%; the Real Return bond (XRB) -3.9%; the Corporate bond (XCB) -1.3%; and Canadian equities (XIU) -2.0%.
Global ETF Portfolio Performance
In 2Q15, the Canadian ETF portfolios tracked in this blog all posted negative returns in CAD terms when USD currency exposure was left unhedged. When USD exposure was hedged, the portfolios generated flat to modestly positive returns. 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 lost 2.3% in CAD when USD exposure was left unhedged, but just lost just 1.6% 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, lost 1.8% if unhedged, but lost just 1.0% if USD hedged.
Risk balanced portfolios underperformed in 2Q15. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 4.2% in CAD terms if USD-unhedged, but lost just 2.5% 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, lost 2.4% if USD-unhedged, but just 1.3% if USD-hedged.
Despite their 2Q15 losses, all of the global ETF portfolios retain decent gains for the year-to-date, ranging from a high of 7.4% for the Levered Risk Balanced Portfolio to a low of 4.3% for the conservative 45/25/30 portfolio.
Recent Performance in Perspective
The weak 2Q15 performance of the unhedged global ETF portfolios was been driven by two factors: the rise in bond yields as US economic data firmed and the Fed continued to tilt toward tightening; and the modest rebound of the CAD versus USD as the price of crude oil recovered. Both of these moves represented partial reversals of trends that generated strong 1Q15 returns (in CAD terms) for our global ETF portfolios. It is interesting question as to whether the 2Q15 reversals have run their course or will continue.
In its June Oil Market Report, the International Energy Agency noted that preliminary data indicate that crude oil inventory builds continued into the second quarter. Global supply and demand balances suggest that the pace of builds is not expected to slow until 3Q15 when supply growth is projected to be reined in. Crude oil inventories remain near record levels and oil production continues to run ahead of demand. The market also has been awaiting the outcome of the Iran nuclear negotiations ahead of a missed June 30 deadline that has now been extended. An agreement could put 1 million barrels of Iranian crude back on the market, but failure would spark renewed tensions.
Fed and BoC policy continue to tilt in opposite directions. In both countries, real GDP contracted in 1Q15. While US economic data has firmed in 2Q, Canada has continued to stumble as the negative effects of lower crude oil prices continue to weigh on economic activity. While the Fed has remained steadfast that policy rate normalization will begin later this year, the BoC has taken a wait-and-see approach since cutting its policy rate in January. The US economy remains better positioned than Canada for a 2H15 rebound and influential members of the FOMC continue to signal the possibility of a rate hike as soon as September.
Three months ago, I said "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." As 3Q15 begins, that seems to be the scenario that is playing out. For that reason, maintaining unhedged exposure to global ETFs remains my preferred portfolio stance.
The more conservative 45/25/30 portfolio (which I have favoured) incurred smaller losses in 2Q15 than the more aggressive 60/40 and Risk Balaced portfolios. As we enter 3Q15 in a continuing uncertain environment, characterized by sluggish global growth and divergent central bank policies, and with rich valuations for US equities, remaining well diversified with an ample cash position continues to be a prudent strategy.
