With just two weeks left in an overly-long federal election campaign. Political leaders, economists and editorialists opine on a daily basis on the nature of the ills facing the Canadian economy and their chosen policy antidotes. Exaggerated claims about how minor policy changes will reinvigorate the Canadian economy and boost the wellbeing of the "middle class" are commonplace.
Canada recorded two consecutive quarters of modest declines real GDP in the first half of 2015. This added fuel to an inane "debate" over whether Canada is in a recession. In July, Bank of Canada Governor Stephen Poloz said this about the recession debate:
I just find the discussion quite unhelpful. It's especially unhelpful when what has happened to the economy is very narrowly defined.
Poloz said the discussion was "especially unhelpful" because the contraction was narrowly focussed on the oil and gas industry and suggested that "the fundamentals are positive and gathering pace in about 80% of the economy".
While I agree that the debate about recession is unhelpful, it for different reasons.
Canada is not experiencing a normal business cycle recession. It is experiencing a severe negative terms of trade shock.
The terms of trade refers to the price of Canada's exports relative to the price of our imports. A negative terms of trade shock occurs when a country's export prices fall relative to the prices of its imports. The terms of trade is of crucial importance to Canada, a medium sized economy that depends heavily on international trade for its growth and prosperity. In Canada's case, the terms of trade are subject to large swings. This is because a large proportion of our exports are commodity based -- oil and gas, metals and minerals, forest products and agricultural products -- and the prices of these commodities are more volatile than the prices of Canada's imports, which are predominantly finished manufacturing products -- motor vehicles, consumer goods and business machinery and equipment. In recent years, oil and gas exports have become increasingly important, accounting for 23% of Canada's goods exports in 1Q 2014, before the recent sharp decline in the price of crude oil. In total, commodity-based exports accounted for 51% of Canada's total exports.
The plunge in the world price of oil, along with weakness in prices of other commodities has dealt a severe blow to Canada's terms of trade. The chart below shows the strong link between the value (in current dollar terms) of Canada's commodity-based exports and the Bank of Canada's Commodity Price Index. Indeed, the link appears to have become even closer over the past 15 years as the development of Canada's oil sands added to its commodity exports.
The latest available data show that the Commodity Price Index was down 40% in 3Q15 from a year earlier. This implies a further significant decline in Canada's commodity-based export values, which were already down 13% from a year earlier in 2Q15.
While it is well understood that falling commodity prices hurt the value of Canada's commodity-related exports, what is less well understood is the direct effect that this has on Canada's Real Gross Domestic Income (GDI). Real GDI is total domestically-generated income, adjusted for inflation, of all sectors of the Canadian economy, including the household sector, the corporate sector and the government sector.
The chart below shows the tight relationship between the value of Canada's commodity-based exports and real GDI for the total economy.
Real GDI fell 1% from a year earlier in 2Q15. Based on the further decline in commodity prices in 3Q15 and the consequent likely further decline in commodity-based export values, real GDI growth is likely to have fallen further in 3Q15, even if real GDP growth turns positive. The only times that real GDI has fallen as sharply over the past four decades are during the 1981-82 recession, the 1991 recession, the bursting of the Tech Bubble in 2001, and the Great Recession of 2008-09.
Canada's prosperity is determined, not by real GDP which is a measure of the how much we produce, or by employment which is a measure of how many of us are working and how many hours we work, but by real GDI, a measure of the real value of the income we receive for the work that we do. The prices that we receive in world markets for the commodities that we extract, process and export are a primary determinant of real GDI growth. A terms of trade shock generated by a sharp fall in commodity prices can have just as negative an impact on Canada's prosperity as a deep business cycle recession, defined by sustained declines in production and employment.
What is also little understood is that a fall in the value of the Canadian dollar which accompanies a fall in commodity prices further erodes real GDI. As the currency weakens, the prices of imported goods, which are dominated by finished consumer goods and business machinery and equipment, rise in Canadian dollar terms. This exacerbates the drop in the terms of trade and increases downward pressure on real GDI.
This is also why BoC Governor Poloz's suggestion that the effects of the terms of trade shock are "narrowly defined" is misleading. When the price of oil and other commodities declines, the real income of oil producers in Alberta falls, but so does the purchasing power of consumers in Ontario, Quebec and other provinces, who must pay more for imported goods, services and foreign travel. The terms of trade shock is shared and spread across regions and industries by the fall in the value of the Canadian dollar. The real incomes of all Canadians suffer when the price of oil plunges and the Canadian dollar depreciates in value.
The problem for politicians and policymakers is that the negative terms of trade shock comes from outside Canada, not from changes in the behaviour of domestic consumers, corporations or governments. The current terms of trade shock has many causes, including the development of new technologies that have lowered the cost of producing oil; the decision by Saudi Arabia and other OPEC countries to continue to pump oil at a high rate rather than cut production to support the oil price; and the slowdown in China's economy which has lowered demand and prices for a broad range of commodities.
Whether or not the downturn in the global commodity super-cycle causes a business-cycle recession measured by GDP and employment is not the most important issue. The most important point to grasp is that Canada is facing a period in which the combined real income of households, corporations and governments are declining and are unlikely to rebound quickly. Even if real GDP resumes growing in the second half of 2015 and employment continues to rise, we will be producing and working more but receiving less real income for our efforts.
What the Economic Debate Should be About
The real economic issue that politicians should be facing is not whether Canada has slipped into a modest business cycle recession, but rather what is the appropriate economic policy response to a lasting negative shock to our national income caused by the fall in the prices of the commodities that we produce.
The Conservative Party wants to stay the course, keeping taxes low, encouraging home-ownership, and pursuing a balanced budget. That is a reasonable start, but does not go far enough in providing incentives to boost growth outside the resource industries.
The Liberal Party wants to raise taxes on high income earners including high-income small business owners, reshuffle child benefits to favour the "middle class", and incur deficits to fund infrastructure projects. The difficulty in this approach will be to maintain business confidence and to control deficit spending in an environment of weak GDI growth.
The New Democratic Party (NDP) wants to raise corporate taxes, impose carbon taxes, expand government's role in child care, and pursue a balanced budget. This is a difficult if not impossible set of promises to deliver on during a period of weak commodity prices.
The worst election outcome, but perhaps the most likely according to current polls, would be a coalition government of the NDP and Liberals. Coalition economic policies would likely result in higher taxes on high income earners, small businesses and corporations, increased spending on government provided child-care and infrastructure, and an early loss of control of budget deficits.
All three political parties and all Canadian voters would be well advised start thinking about what kind of pro-investment, pro-growth policies Canada needs to pursue in a period when the main economic engine and source of national prosperity has stalled and shifted into reverse.
Global ETF portfolios for Canadian investors turned in mixed performances in 3Q15. Equity-heavy portfolios incurred losses, while bond-heavy, risk balanced portfolios posted gains. Performance would have been much worse had it not been for the 6.2% depreciation of the Canadian dollar relative to the USD that increased C$ returns for Canadian investors in USD denominated global ETFs.
As in 2Q15, global economic developments were mixed but, once again, generally disappointing:
- The forecast for global real GDP growth in 2015 fell further in 3Q. Eight of the twelve large economies that I track saw downward revisions in their 2015 growth forecast. The US growth forecast edged up in 3Q after upward revisions to 2Q growth. However, real GDP growth forecasts for 2015 were revised down for the Eurozone, Japan, Canada, Australia, China, Korea, Brazil and Russia in 3Q15.
- Signs of weaker global growth, and particularly weaker Chinese growth, contributed to a fall back in crude oil prices following a modest recovery in 2Q15.
- Forecasts of 2015 inflation fell in nine out of the twelve countries in 3Q15 as oil prices fell back and deflation worries increased.
- China, Canada and Russia cut their policy rates in 3Q15, while Brazil was again forced to hike its policy rate in response to rising inflation and a weakening currency.
- Bond yields fell virtually everywhere in 3Q15, after rising virtually everywhere in 2Q15.
- China's equity market continued its' sharp correction that began in the final weeks of 2Q, falling by over xx% from its highs. The PBoC devalued the CNY sending shock waves through global markets.
- Emerging market turbulence, especially in China, combined with confusion over Fed policy added to worries about corporate earnings and triggered corrections in major global equity markets.
Despite below target inflation, the Fed continued to stress the need for "policy normalization". The window appeared to be open for a rate hike in September after growth rebounded in 2Q and employment gains remained strong through August. However, the Fed passed on the opportunity, apparently concerned that in light of China's growth slowdown and emerging market financial outflows, a Fed rate hike might further destabilize global financial markets. In the event, the non-action by the Fed appeared to exacerbate concerns of global growth slowdown, and sent equity markets into a further tailspin.
The Bank of Canada followed up on a January rate cut with a second 25 basis point easing in July, as it became increasingly apparent that the economy had suffered a second consecutive modest contraction in 2Q. The Canadian dollar, which had firmed versus the USD in 2Q on moderately higher crude oil prices, came under renewed downward pressure in 3Q as China's growth slowed and oil prices fell back.
Global Market ETFs: Performance for 3Q15
In 3Q15, with global growth and inflation expectations weakening, crude oil prices falling, and the USD appreciating by 6.6% against the CAD, the best global ETF returns for Canadian investors were in US government and investment grade corporate bonds. The worst returns were in commodities and Emerging Market equities. The chart below shows 3Q15 and year-to-date returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.
In CAD terms, 11 of 19 ETFs posted losses, while 8 posted gains. In local currency terms, only 3 of the 19 RTFs posted gains.
The best returns, in CAD terms, were in US Long Teasury Bonds (TLH) +10.6%; US Investment Grade bonds (LQD) +7.8%; non-US Developed Market bonds (BWX) +6.7%; and US Inflation-linked bonds (TIP) +5.6%.
The worst losses were in the commodity ETF (GSG), which returned -13.8% in CAD, and the Emerging Market equity ETF (EEM), which returned -11.8%.
All of the Canadian ETFs that we track posted losses in 3Q15, but Canadian bond ETFs outperformed Canadian equity ETFs. The Long Bond ETF (XLB) returned -0.3%; the Real Return bond (XRB) -0.6%; the Corporate bond (XCB) -0.8%; while Canadian equities (XIU) returned -6.8%.
Global ETF Portfolio Performance
In 3Q15, the global ETF portfolios tracked in this blog posted mixed returns in CAD terms, when USD currency exposure was left unhedged.
When USD exposure was hedged, the portfolios all posted negative 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 lost 5.2% 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 1.1% if unhedged, but lost 4.1% if USD hedged.
Risk balanced portfolios outperformed in 3Q15 if USD exposure was left unhedged. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 1.6% in CAD terms if USD-unhedged, but lost 5.0% 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, gained 0.1% if USD-unhedged, but lost 4.6% if USD-hedged.
Despite their 3Q15 losses, all of the global ETF portfolios retained gains for the year-to-date in CAD terms if USD exposure was left unhedged. Year-to-date returns ranged from a high of 9.3% for the Levered Risk Balanced Portfolio to a low of 3.5% for the conservative 45/25/30 portfolio. If the portfolios were USD hedged, they all posted year-to-date losses, ranging from -3.0% for the 60/40 portfolio to -4.9% for the Levered Global Risk Balanced Portfolio. Interestingly, the Levered Global Risk Balanced Portfolio is the best year-to-date performer if USD unhedged, but the worst performer if USD hedged.
Recent Performance in Perspective
The mixed 3Q15 performance of the USD unhedged global ETF portfolios was driven by two factors: the fall in bond yields as global, and particularly Chinese growth, continued to slow; and the sharp weakening of the CAD versus USD as the Canadian economy contracted for two consecutive quarters, the Bank of Canada delivered another rate cut, and price of crude oil and other commodities fell.
Fed and BoC policy continue to tilt in opposite directions. US real GDP growth, while disappointing, is still expected to reach 2.5% in 2015, double that expected in Canada. However, weak September readings for the ISM manufacturing PMI and US nonfarm payrolls, suggest that the US economy is losing momentum again. While Canada's economic data has firmed so far in 3Q, the RBC manufacturing PMI showed a sharp contraction in September as the negative effects of lower crude oil prices continued to weigh on economic activity. While some Fed officials have resumed signalling a rate hike before year end, a US tightening this year is clearly in doubt. The BoC seems much more likely to cut rates again than to raise them over the next six months.
Three months ago, I said "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." As 4Q15 begins, that still seems to be the scenario that is playing out.
The more conservative 45/25/30 portfolio (which I have favoured) was less volatile and incurred smaller losses in 3Q15 than the more aggressive 60/40 portfolio. The Risk Balanced portfolios outperformed because of their larger positions in government, corporate bonds and inflation-linked bonds. As we enter 4Q15, the environment remains uncertain, characterized by weak and divergent global growth and central bank policies. US equity valuations have become less stretched but are still expensive. Global recession risks are rising, not falling as expected by the consensus. Remaining well diversified with substantial US dollar exposure and an ample cash position continues to be a prudent strategy.
