The Biggest Global Macro Misses of 2016

As the year comes to a close, it is time to review how the macro consensus forecasts for 2016 that were made a year ago fared. Each December, I compile consensus economic and financial market forecasts for the year ahead. When the year comes to a close, I take a look back at the prognostications and compare them with what we know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move --  sometimes dramatically --  when the consensus is surprised and a different outcome transpires. When we look back, with 20/20 hindsight, we can see what the surprises were and interpret the market movements the surprises generated.  

Of course, the biggest forecast misses of 2016 were not in the economic indicators and financial markets, but in the political arena. The consensus views of political pollsters were that Brits would vote to remain in the European Union and that Hilary Clinton would win the US Presidential election. Instead, the actual outcomes were Brexit and President-elect Donald Trump. These political misses have had and will continue to have significant economic and financial market consequences. In the context of these political surprises, it's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to understand 2016 investment returns.

Real GDP

Since the Great Financial Crisis, forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2016. Average real GDP growth for the twelve countries we monitor is now expected to be 3.0% compared with a consensus forecast of 3.5%. In the twelve economies, real GDP growth fell short of forecasters' expectations in eleven and exceeded expectations in just one. The weighted mean absolute forecast error for 2016 was 0.51 percentage points, down a bit from the 2015 error, but still sizeable relative to the actual growth rate.

Based on current estimates, 2016 real GDP growth for the US fell short of the December 2015 consensus by 0.8 percentage points, a bigger downside miss than in 2015 (-0.5) or 2014 (-0.1). The biggest downside misses for 2016 were for Russia (-1.6 pct pts), Brazil (-1.4), India (-1.1) and Mexico (-0.8). China's real GDP  beat forecasts by 0.1. Canadian forecasters missed by -0.5 pct pts, a little less than the average miss. On balance, it was a sixth consecutive year of global growth trailing expectations.

CPI Inflation

Inflation forecasts for 2016 were also, once again, too high. Average inflation for the twelve countries is now expected to be 2.2% compared with a consensus forecast of 2.6%. Nine of the twelve economies are on track for lower inflation than forecast, while inflation was higher than expected in three countries. The weighted mean absolute forecast error for 2016 for the 12 countries was 0.33 percentage points, a much lower average miss than in the previous two years.

The biggest downside misses on inflation were in Russia (-0.9 pct pts), India (-0.7), Australia (-0.7), and Korea (-0.6). The biggest upside miss on inflation was in China (+0.5). UK and US inflation were also slightly higher than forecast.

Policy Rates

Economists' forecasts of central bank policy rates for the end of 2016 once again anticipated too much tightening by developed market (DM) central banks, but for emerging market (EM) central banks, it was a more mixed picture.

In the DM, the Fed failed to tighten as much as forecasters expected. The biggest DM policy rate miss was in the UK, where the Bank of England had been expected to tighten, but instead cut the policy rate after the Brexit vote. The ECB, the Bank of Japan, the Reserve Bank of Australia and the Bank of Canada also unexpectedly cut their policy rates. In the EM, the picture was more mixed. In China, where inflation was higher than expected, the PBoC did not deliver expected easing. In Brazil and India, where inflation fell more than expected, the central banks eased more than expected. In Russia where inflation also fell, Russia's central bank eased less than expected. In Mexico, where the central bank was expected to tighten, the tightening was much greater than expected after the Trump election victory caused the Mexican Peso to fall sharply.

10-year Bond Yields

In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. Weaker than expected growth and inflation combined with major central banks’ decisions to delay tightening or to ease further pulled 10-year yields down in most countries compared with forecasts of rising yields made a year ago.

In five of the six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.33 percentage points. The biggest misses were in the UK (-0.88 pct. pt.), Eurozone (proxied by Germany, -0.49), Japan (-0.39), and Canada (-0.34). In the EM, bond yields were lower than forecast where inflation fell more than expected, in India and Russia. The biggest miss in the bond market was in Brazil, where inflation fell much more than expected and reduced political uncertainty saw the 10-year bond yield almost 4 percentage points lower than forecast. Bond yields were higher than expected in China, where inflation was higher than expected, and much higher than expected in Mexico where political risk increased with Trump's election.

Exchange Rates

Currency moves against the US dollar were quite mixed in 2016.  The weighted mean absolute forecast error for the 11 currencies versus the USD was 5.4% versus the forecast made a year ago, a smaller error than in the previous two years.

The USD was expected to strengthen because many forecasters believed the Fed would tighten two or three times in 2016. Once again the Fed found various reasons to delay, with only one tightening occurring on December 14. If everything else had been as expected, the Fed's delay would have tended to weaken the USD. But everything else was not as expected. Most other DM central banks eased policy by more than expected and the ECB and the BoJ implemented negative policy rates. In addition, oil and other commodity prices rallied causing commodity currencies like RUB, AUD, and CAD to strengthen more than forecast.

The biggest FX forecast misses were casualties of the big political consensus misses on Brexit and the US presidential election. The GBP was almost 18 percent weaker than forecast a year ago, while the MXN was 17% weaker than forecast after President-elect Trump promised to “tear up” NAFTA. The biggest miss on the upside was for BRL (+27%) where President Dilma Rousseff’s impeachment received a standing ovation from the currency market.

North American Stock Markets

A year ago, equity strategists were optimistic that North American stock markets would turn in a decent, if unspectacular, performance in 2016. However, despite a year characterized by weaker-than-expected real GDP growth and inflation and by political surprises that were widely-perceived as negative, North American equity performance exceeded expectations by a substantial margin. I could only compile consensus equity market forecasts for the US and Canada. News outlets gather such year-end forecasts from high profile US strategists and Canadian bank-owned dealers. As shown below, those forecasts called for 2016 gains of 5.5% for the S&P500 and 10.0% for the S&PTSX Composite.
  

As of December 14, 2016, the S&P500, was up 13.6% year-to-date (not including dividends) for an error of +8.1 percentage points. The S&PTSX300, rebounding from a sizeable decline in 2015, was up 17.1% for an error of +7.1 percentage points.

Globally, actual stock market performance was less impressive than that of North American markets, with two notable exceptions, Russia and Brazil. 

Stocks performed poorly the Eurozone and Japan, where deflation worries caused central banks to adopt negative interest rates. China saw the biggest equity loss (-11.3%) of the markets we monitor as slowing growth and fears of currency devaluation fueled large capital outflows. In the US, where the Fed delayed monetary policy tightening, and in the UK, where the BoE unexpectedly eased, equities posted solid gains. In Canada, and Australia, where central banks eased more than expected, equities were also boosted by a recovery in commodity prices. Russia and Brazil posted huge equity market gains, rebounding from large currency and equity market declines in 2015.


Investment Implications

While the 2016 global macro forecast misses were similar in direction, they were generally smaller in magnitude relative to those of 2015 and the investment implications were different. Global nominal GDP growth was once again weaker than expected, reflecting downside forecast errors on both real GDP growth and inflation. In 2016, most central banks either tightened less than expected or eased more than expected, but continued political uncertainty, weaker than expected nominal GDP growth and the strong US dollar held the US equity market in check through early November prior to the US election. 

Although many strategists argued that a Trump victory would be bad for US equities, because of uncertainty over his policies in general and his protectionist views in particular, the opposite reaction followed the election. US equities outperformed by a wide margin. US small caps and financials led the gains on Trump’s promise of reduced regulation, corporate tax reform and a steeper yield curve. UK equities rallied in the aftermath of Brexit, boosted by the increased competitiveness generated by the sharp depreciation of the GBP. In Japan and the Eurozone, where governments failed to enact structural reforms and where central banks experimented with negative policy interest rates, equities badly underperformed. In Canada, Australia, Brazil, Mexico and Russia, rebounding commodity prices supported equity markets. In China, one of the few countries where reported nominal GDP growth was stronger than expected (despite on-the-ground reports of economic slowdown), equity prices fell as capital fled the country.

Similar to the previous two years, downside misses on growth and inflation and central bank ease in most countries provided solid, positive returns on DM government bonds in the first 10 months of 2016. However, after the Trump election victory, as markets priced in stronger US growth and inflation and bigger US budget deficits, government bonds across the globe gave back much of their gains and significantly underperformed equities in all regions.

Smaller divergences in growth, inflation and central bank responses, along with firming crude oil and other commodity prices, led to smaller currency forecast errors. For Canadian investors, the stronger than expected 5% appreciation of CAD against the USD meant that returns on investments in both equities and government bonds denominated in US dollars were reduced if the USD currency exposure was left unhedged. The biggest losers for Canadian investors were Eurozone and Chinese equities, as well as most DM sovereign bonds, especially if unhedged.

As 2017 economic and financial market forecasts are rolled out, it is worth reflecting that such forecasts form a very uncertain basis for year-ahead investment strategies. The high hopes (and fears) that markets are currently pricing in for a Trump presidency will surely be recalibrated against actual policy changes and foreign governments’ policy reactions. 

The lengthy period in recent years of outperformance by portfolios for Canadian investors that are globally diversified, risk-balanced and currency unhedged may have run its course. Global asset performance may be shifting toward a more US-centric growth profile that could also benefit Canada if Trump’s protectionist tendencies are implemented only against China, Mexico and any other countries a Trump-led America deems to unfair traders. While such an outcome is possible, 2017 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. As an era of rising asset values supercharged by ever-easier unconventional monetary policies seems to be coming to an end, the scope for new surprises to cause dramatic market moves has perhaps never been higher.

Global Macro Reaction to President Trump

To the surprise of many, it's President Trump. 

In the days ahead of the election, global equities sold off when Donald Trump narrowed Hillary Clinton's lead in the polls after the FBI reopened the investigation into Hillary's emails. After the FBI announced that there were no grounds to prosecute on the Sunday before the election, global equities rallied as pollsters raised their odds of a Clinton victory. 

On election night, when it became evident that Trump might win the election, Asian equity markets fell and Dow futures plunged almost 800 points. After his conciliatory acceptance speech, equity futures recovered and, after opening lower on Wednesday morning, the US equity market began a strong three day rally that was not expected.

This post looks at the early reaction of global markets to the Trump victory through the lens of the global ETFs that we normally track.

US Equity ETF's Biggest Winners, EM Assets Biggest Losers

The chart below shows the returns on global ETFs, from the close on election day, November 8 (before results were known), until the close on Friday, November 11.  

The returns are shown both in USD terms and in CAD terms, which are of interest to Canadian investors. The USD gained 1.9% versus CAD from the close on November 8 to the close on November 11, thereby pushing up CAD returns on USD-denominated ETFs.

In USD terms, US equities were the only ETFs that posted gains after the Trump win. The biggest gainer among the ETFs we track in this blog was the US small-cap equity ETF (IWM) which gained 7.1% in USD terms and 9.2% in CAD terms.  The US large-cap equity ETF (SPY) gained 1.0% in USD terms and 3.0% in CAD.

Other global equity ETFs didn't fare as well. The emerging market equity ETF (EEM) posted a large loss, with Canadian (XIU), Eurozone (FEZ) and Japanese (EWJ) equities posting more modest losses in USD terms.

The biggest losers were emerging market ETFs, led by the emerging market local currency bond ETF (EMLC) -8.7% in USD terms, the emerging market equity ETF (EEM) -7.8%, and the emerging market US dollar bond ETF (EMB) -5.7%. 

All other asset class ETFs posted losses.  In commodities, the gold ETF (GLD) was down 3.7% in USD terms, while the commodity ETF (GSG) was down 2.0%, as oil price declines outweighed gains in copper and other metals. In sovereign bonds, Canadian (XLB), US (TLH) and non-US (BWX) bond ETFs all lost 3-4% in USD terms. US (TIP) and Canadian (XRB) inflation-linked bonds outperformed their sovereign counterparts, but not by much, and the non-US inflation linked bond ETF (WIP) underperformed its sovereign counterpart. Corporate bond ETFs also posted losses, as US investment grade (LQD), US high yield (HYG) and Canadian investment grade (XCB) all posted losses of 2-3% in US terms.

While US equities performed best, it is interesting to look at little deeper into equity returns as shown in the chart below, which looks at some other equity sector and country ETFs.

The chart shows that when looked at by sector and by country, there were some much bigger winners and losers. The US bank stock ETF (KBE) gained 11.5% in USD and 13.6% in CAD. The US defence and aerospace (ITA) and health care (IYH) ETFs also both outperformed the S&P500 by a wide margin, while the technology ETF (IYW) posted a loss of 1.1% in USD. As for country or regional equity ETFs, the Mexico (EWW) and China (MCHI) equity ETFs were big losers, down 17.9% and 4.8% respectively in USD terms. Interestingly, the Russia ETF was one of the few gainers. The EAFE (EFA) and Canada (EWC) equity ETFs were more modest losers. 

Interpreting the Global Macro Message from the Markets

The reaction of global asset markets aligns reasonably well with the policy priorities of President-elect Trump. These priorities (in no particular order) seem to be:

• Repeal/replace Obamacare
• Increase spending on infrastructure and defence
• Reject the Paris Agreement on climate change 
• Reform and cut taxes
• Reduce regulation of banks and other industries
• Tear up NAFTA, reject TPP, raise tariffs on Chinese and Mexican imports
• Tighten immigration, deport (some) illegal immigrants

The anticipated positive effects on US small business profitability of repealing Obamacare, reduced red tape, lower taxes, and reduced competition from Mexico and China triggered the outsized gains in US small-cap equites (IWM). US large-cap equities also gained, but significantly underperformed small-caps, as large global companies face a more mixed picture as they depend more on global trade and supply chains than do small-caps.

The anticipated fiscal stimulus reflected in plans for lower taxes and increased infrastructure and defence spending is likely to boost both growth and fiscal deficits in the short term. The market reacted by lifting defence and construction equipment stocks and by selling off US Treasury bonds.

With fiscal policy taking the lead in boosting growth, US monetary policy will likely move more quickly to normalize the policy rate and be less likely in the future to resort to unconventional policy measures, including quantitative easing and negative policy rates. As a result, markets are signalling an expectation that bond yields will continue to rise from record lows. 

Tightening immigration and deporting illegal immigrants is likely to reduce labor supply in an already tight US labor market, thereby adding to wage pressures. Raising tariffs and rejecting or weakening free trade agreements will put further upward pressure on inflation, more bad news for bond ETFs. 

Anticipation of rising interest rates, a steepening yield curve, and talk of repeal of (some of) the Dodd-Frank bank regulations imposed following the financial crisis, provided a huge boost to US bank ETFs.

Trump's plans to raise tariffs and reject or renegotiate trade deals, is clearly bad news for countries dependent on trade with the United States, including Mexico, Canada and China. It is also bad news for US industries which have developed major supply chains in these countries, including the US technology and auto industries.

The intention to reject the Paris Agreement on climate change will free US energy producers from concerns about possible emissions targets or carbon taxes and encourage greater US oil and coal production. It will also likely lead to reduced subsidies and other incentives for technology companies pursuing green energy projects.

Global asset markets have adjusted swiftly to a changed set of expectations is the wake of the election of Donald Trump. Details of his policies remain unknown, but the market clearly senses, and already reflects, the broad strokes of President-elect Trump's policy priorities. What remains to be seen, is how quickly and how fully his campaign promises will be implemented.

Global Monetary Spillovers and Bank of Canada Independence

In a recent post, I discussed The Breakdown of Faith in Unconventional Monetary Policy. Zero interest rate policy (ZIRP), quantitative easing (QE), forward guidance on policy rates and, more recently, negative interest rate policy (NIRP) have been undertaken in various forms and to varying degrees by the four major DM central banks, the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE). Some smaller central banks have dabbled in unconventional monetary policies (UMPs), including the Swiss, Danish and Swedish central banks. 

But, from the perspective of other countries, where the domestic central banks have not been aggressive participants in UMP, the important question is how do these policies affect their economies, their financial markets and the independence of their monetary policies. Recent research has focused on the global spillovers from UMPs of the major central banks into the monetary policies and financial conditions of other global economies, especially EM economies and some of the small open DM economies. This research has found strong evidence that UMP has spilled over into other economies, complicating the conduct of national monetary policies and, at times, creating risks to financial stability.

Evidence of Spillovers

In a their paper, International Monetary Spillovers, Boris Hofmann and Előd Takáts of the Bank for International Settlements (BIS) state that:

We find economically and statistically significant spillovers from the United States to EMEs [emerging market economies] and smaller advanced economies [including Canada]. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify. We also find that monetary spillovers take place under both fixed and floating exchange rate regimes.

Jaime Caruana, General Manager of the BIS, in a recent paper entitled, The international monetary and financial system: eliminating the blind spot, makes the following observation:

Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. … [L]iquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, the international monetary and financial system as we know it today not only does not constrain the build-up of financial imbalances, it also does not make it easy for national authorities to see these imbalances coming. 

Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years. 

Caruana has identified four channels by which global liquidity conditions can spill over:

1. through the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world via policy reactions in the other economies (e.g., easing to resist currency appreciation and maintain competitiveness);
2. through the international use of currencies: most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro area monetary policies immediately affect financial conditions in the rest of the world. … A key observation in this context is that US dollar credit to non-bank borrowers outside the United States has reached $9.2 trillion, and this stock expands on US monetary easing;
3. through the integration of financial markets, which allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere; and 
4. through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.

Caruana concludes:

Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result. What I have just described is the spillovers and feedbacks – and the tendency to create a global easing bias – with monetary accommodation at the centre. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the centre begin to rise, or even seem ready to rise – as suggested by the taper tantrum of 2013.

Implications of Spillovers for Canada

For smaller, open DM economies like Canada, the spillovers from the major central banks’ UMPs are readily visible. 

When the major central banks lowered their policy rates to near zero, the Bank of Canada (BoC) did likewise. This was partly driven by concerns about domestic economic weakness and partly to resist appreciation of the Canadian dollar and the resulting loss of competitiveness. When the BoC became concerned about what proved to be a temporary increase in inflation and raised its policy rate in 2011, the Canadian dollar appreciated strongly.

When major central banks engaged in Quantitative Easing, through large-scale purchases of their own sovereign debt, demand for close substitutes like Canadian sovereign debt increased and forced down Canadian long term government bond yields.

When major central banks, including the Bank of Japan, ECB and BoE moved to NIRP, the Bank of Canada announced that its research showed that it, too, could lower its policy rate below zero if necessary.  

The net result is that Bank of Canada policy has become both constrained by and heavily influenced by the UMPs of the major central banks. Canadian liquidity and financial conditions reflect not just the BoC’s policy rate setting, but also and more importantly, the extraordinarily accommodative policies of the major central banks. The BoC has had no choice but to keep its policy rate low. Failing to do so would have created even greater exchange rate appreciation that would have stunted growth even more and pushed inflation even further below the 2% target.

The ultra-low interest rates imported through global financial markets, have led to a credit boom. The credit boom has been characterized by heavy borrowing by Canadian households and some sectors of Canadian business, such as the energy sector. 

The heavy mortgage borrowing by households has contributed to overheated housing markets in Vancouver and Toronto. As I have argued in a previous post, the housing boom in these cities was amplified by easy credit policy by the People's Bank of China (PBoC), which saw synchronized housing price surges in large Chinese and Canadian cities. With inflation below target and the BoC unable to raise its policy rate to quell this overheating, federal, provincial and municipal governments have intervened with macro-prudential policies, such as tighter mortgage rules, the recent tax on foreign homebuyers in Vancouver, and the federal government's closing of the capital gains tax loophole for foreign homebuyers.

When energy prices were high, supported by near-zero policy rates and the liquidity boost provided by quantitative easing by the major central banks, Canadian energy companies issued large amounts of corporate debt at low rates. When the surge in global investment in fracking technology spurred strong growth in energy supply at a time of lacklustre demand growth, energy prices collapsed and default rates jumped sharply in the energy sector. 

The integration of global financial markets means that global uncertainty and risk aversion is instantly transmitted to Canadian markets for stocks and bonds. Canadian markets and asset prices are now as sensitive, if not more sensitive, to changes in policies of the major central banks as they are to changes in Bank of Canada policy.

Monetary Spillovers and Central Bank Independence

This raises the important question of whether the central banks of smaller open economies, like Canada, can pursue independent monetary policy.

Canada's Nobel Prize winning economist, Robert Mundell, laid the groundwork with what he referred to as "the impossible trinity" and what others have called the "monetary trilemma". As explained by Paul Krugman in 1999,

Mundell proposed the concept of the "impossible trinity"; free capital movement, a fixed exchange rate, and an effective monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.

Wikipedia summarizes with the help of the diagram below: "The Impossible Trinity" or "The Trilemma", in which two policy positions are possible. If a nation were to adopt position a, for example, then it would maintain a fixed exchange rate and allow free capital flows, the consequence of which would be loss of monetary sovereignty.

When Canada let its exchange rate float in 1970, it opted for position b on the chart, accepting the need for a flexible exchange rate because it wanted to maintain free international capital mobility and a sovereign (i.e., independent) monetary policy.

But global monetary policy spillovers now challenge the ability of smaller central banks to conduct an independent monetary policy, even if the central bank is prepared to maintain a flexible, market-determined exchange rate. 

In a paper entitled Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence, Hélène Rey of the Kansas City Fed argues,

[M]onetary policy [of] the center country [i.e. the major central banks] … affects leverage of global banks, credit flows and credit growth in the international financial system. This channel invalidates the "trilemma", which postulates that in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. Instead, while it is certainly true that countries with fixed exchange rates cannot have independent monetary policies in a world of free capital mobility, my analysis suggests that cross-border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange-rate regimes.

Implications for Canadian Monetary Policy 

At a minimum, it is high time that the Bank of Canada openly analyze and discuss with the public, the influence that the major central banks' unconventional monetary policies are having on the Canadian economy and financial markets.

How will the future paths of the major central banks policies influence and constrain the policies of the Bank of Canada?

With the Fed signalling that it plans to resume a gradual tightening of policy at a time when the Canadian economy is struggling to adjust to much lower prices for oil and other commodities, the likely spillover will be a premature and possibly excessive, tightening of Canadian financial conditions. Should the Bank of Canada keep pace with Fed tightening or hold the line on Canada’s policy rate and thereby encourage further depreciation of the Canadian dollar? Or should it cut its own policy rate to offset the spillover of tighter financial conditions arising from Fed tightening?

If Fed tightening pushes up global bond yields (and therefore Canadian mortgage rates) how should the BoC respond to the likely fallout in the Canadian housing market if housing prices experience a sharp correction? 

If US and global growth falters and the Fed returns to more aggressive use of UMP, including a zero or even negative Fed policy rate and a resumption of QE, can the BoC afford not to follow?

If the BoJ and/or the ECB push policy rates further into negative territory, should the Bank of Canada be prepared to follow?

If Japan adopts ‘helicopter money’ or central bank financed fiscal stimulus, should the BoC consider the same direction?

Is there any alternative to mimicking the unconventional policies of the major foreign central banks? If the answer is yes, then how will the tradeoffs between the interests of savers and borrowers and between the interests of exporters and domestic consumers be balanced? 

If the answer is no, then what remains of the independence of the BoC? If its' policy rate and Canadian bond yields reflect spillovers from foreign central bank UMPs can the BoC independently pursue its' 2% inflation target? Are its policies not then dominated by foreign central bank actions or possibly by its own government’s needs to finance new spending and hold down debt service costs through financial repression?

These are tough and important questions that are not even being discussed in Canada.

Global ETF Portfolios for Canadian Investors: 3Q16

The stay-at-home strategy continued to perform well in 3Q16 after three years of underperforming the globally diversified ETF portfolios that we track in this blog. Crude oil prices finished September little changed from where they were at the end of June. The US Fed remained on hold but laid the groundwork for another tightening move before the end of the year. Meanwhile, the Bank of Canada stood pat and talked of rates staying low for long.

The price of WTI crude oil, which began the year at US$37 per barrel finished 3Q16 at US$48/bbl, virtually unchanged from the 2Q closing level. The BoC decision to stand pat, combined with the Fed continuing to signal one tightening before yearend, sparked a 1.6% depreciation in the Canadian dollar in 3Q, ending September at US 76.2 cents, down from 77.4 cents at the end of June.

Flat crude oil prices combined with the 1.6% depreciation in the Canadian dollar in 3Q16 provided modest headwinds for stay-at-home portfolios. Unhedged global ETF portfolios were able to outperform in a quarter when both stocks and bonds continued to rally. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 4.0% in Canadian dollars. Most of the unhedged Global ETF portfolios that I track in this blog posted slightly stronger gains for 3Q16. Since we began monitoring at the beginning of 2012, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio.

Global Market ETFs: Performance for 3Q16

In 3Q16, with central banks remaining dovish and the USD appreciating 1.6% against the CAD, global ETF returns favoured foreign equities. In CAD terms, 18 of the 19 ETFs we track posted positive returns, while just one ETF posted a loss for the quarter. The chart below shows 3Q16 returns (blue bars) and year-to-date returns (green bars), in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainers in 3Q16 were global equity ETFs, including Japan equities (EWJ) which returned 10.8% in CAD terms, followed closely by US small cap equities (IWM) at 10.7% and emerging market equities (EEM) at 10.2%. The best performing bond ETFs were US High Yield Bonds (HYG) which returned 6.1% in 3Q16, followed by non-US inflation-linked bonds (WIP)  at 5.4%. The Gold ETF (GLD) returned 1.0%. The worst performer was the commodity ETF (GSG) which returned -3.0% in CAD terms.

For 2016 year-to-date, the best performing ETFs in CAD terms were the gold ETF (GLD), the Canadian equity ETF (XIU), and the Canadian long bond ETF (XLB). The worst year-to-date performers were Eurozone equities (FEZ), commodities (GSG) and Japanese equities (EWJ).
  

Global ETF Portfolio Performance for 3Q16

In 3Q16, the Global ETF portfolios tracked in this blog all posted solid returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the unhedged portfolios performed better, reversing the pattern of the previous two quarters.

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 4.0% in 3Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 3Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 4.7% in CAD terms if unhedged, but had a lower return of 3.4% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 4.4% if unhedged and 3.2% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 4.4% in CAD terms when USD exposure was left unhedged, and 3.2% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 3.9% if unhedged and 2.9% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio remained the best performer, returning 10.7% ytd, outperforming all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 15.0% in CAD terms.

Looking Ahead

The key market events of 2016 that have influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that slow global growth and below-target inflation in the major DM economies will delay and moderate any tightening by the Fed and encourage further easing by other major central banks; the BoC's signalling that its policy rate will likely remain low for long; and a gradually improving balance between global demand and supply of crude oil. These events occurred against a backdrop of further downward revisions to global growth  and inflation expectations and rising political uncertainty as the UK voted for Brexit and the polls tightened in the US presidential election race. So far, markets have shrugged off the political uncertainty and been encouraged by continued extremely accommodative monetary policies.

After rising at a 2.5% annualized pace in 1Q, Canada's economy contracted at a 1.6% pace in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. The expected 3Q16 rebound in growth is encouraging but in reality only returns the Canadian economy to subpar year-over-year growth of just over 1%. US growth averaged just 1.1% in the first half of 2016, and the Atlanta Fed's GDP Now forecast currently points to 2.4% growth for US real GDP in 3Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.2% currently from 1.9% in December and for the US to 1.5% currently from 2.4% in December.

Global growth and inflation prospects have also cooled. According to JPMorgan, global growth for 2016 is now projected at 3.1%, down from the December consensus forecast of 3.4%. Global consumer price inflation is now projected at 2.3%, down from the December consensus forecast of 2.7%. 

Meanwhile, Fed Chair Janet Yellen's message has shifted from firmly on hold ahead of the Brexit referendum to clear support for a rate hike before the end of 2016 now. At the same time, the Bank of  Canada Governor Poloz has made it clear that the BoC is content to pass the stimulus baton to Finance Minister Morneau, who will soon present a Fiscal Update that will confirm that the government is content to pursue large and growing deficits in the name of "growing the economy".

The key event in the final quarter of 2016 is, without a doubt, the US presidential election. While it can be argued that Trump's economic policy platform, if effectively implemented, would be more advantageous to Canada than Clinton's, there is no doubt that the Canadian voters who gave the Trudeau Liberals a strong parliamentary majority would prefer to see Clinton win. From a market perspective, it appears that risk markets that have so heavily depended on central bank unconventional monetary policies, would prefer a Clinton victory as more likely to see a shift toward a more expansionary fiscal policy and perhaps eventually "helicopter money". 

This leaves global markets in a potentially vulnerable position. Equity market valuations are increasingly stretched. Government bond market valuations also remained stretched as global 10-year bond yields continue to test new lows.

The declines in global bond yields are a reflection of growth disappointments and falling inflation expectations around the world and the market's assessment that this will result in continued experimentation with unconventional monetary policies. We are living in an upside down world in which weak growth and disinflation seem to lift financial asset prices because investors expect that such outcomes will spur even more accommodative monetary policy.

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of political risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.

The Breakdown of Faith in Unconventional Monetary Policy

We are witnessing a breakdown of faith, outside central banks, in unconventional monetary policy (UMP). In recent days and weeks, the attack on UMP has intensified from a wide array of analysts including current and former monetary officials as well as highly regarded financial market commentators. 

Inside central banks, faith remains strong, as witnessed at the Jackson Hole meetings in August, where the keynote speaker, Fed Chair Janet Yellen concluded,

New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. 

As unconventional policy comes under attack, central bank credibility is eroded and diametrically opposing views are forming over what direction monetary policies should take next. 

Opponents of UMP favour a gradual unwinding of unconventional monetary policies of key central banks, namely the US Federal Reserve, the Bank of Japan (BoJ) and the European Central Bank (ECB), including quantitative easing (QE) and negative interest rate policy (NIRP).

Supporters of UMP favour even more aggressive use of these policies, by both the BoJ and the ECB to combat slow growth and deflation now.  Some advocate going further to implement "helicopter money" or monetary financing of new fiscal stimulus. 

Which of these policy scenarios plays out over the next few years will dramatically influence both economic and financial market outcomes, not only in the economies of the central banks employing unconventional policies, but across the global economy as the spillovers from the policies of the major central banks reverberate through global financial conditions.

The Critique of Unconventional Monetary Policy

Perhaps the most damaging critiques of UMP have come from current and former monetary officials.

In July, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), along with his colleague Anna Zubai, published a paper titled "Unconventional monetary policies: a re-appraisal". The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,

They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.

Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. … But no one had anticipated that they would spread to the rest of the world so quickly and would become so daring.

[T]his development is a risky one. Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.

In August, just as central bankers were congregating at Jackson Hole, Wyoming for their annual get-together, former Federal Reserve Governor Kevin Warsh published another, more strongly-worded, broadside against UMP in an op-ed in the Wall Street Journal.

The conduct of monetary policy in recent years has been deeply flawed. 

The economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.

The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality. 

At the Jackson Hole meeting, Christopher Sims, the influential Professor of Economics at Princeton University, attempted to answer the question of why unconventional monetary policies, including negative policy interest rates, have been ineffective in boosting growth and returning inflation to target levels, with the following assessment:

Reductions in interest rates can stimulate demand only if they are accompanied by effective fiscal expansion. For example, if interest rates are pushed into negative territory, and the resources extracted from the banking system and savers by the negative rates are simply allowed to feed through the budget into reduced nominal deficits, with no anticipated tax cuts or expenditure increases, the negative rates create deflationary, not inflationary, pressure.

These critiques from current and former monetary policy insiders, give added weight to the arguments against UMP that have been coming from private sector analysts for years. To quote a few recent examples,

James Grant, Publisher, Grants Interest Rate Observer: 

What is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful.   

 John Hussman, President, Hussman Econometrics Advisors:

By driving interest rates to zero, central banks intentionally encouraged investors to speculate long after historically dangerous ‘overvalued, overbought, overbullish’ extremes emerged. In my view, this has deferred, but has not eliminated, the disruptive unwinding of this speculative episode. By encouraging a historic expansion of public and private debt burdens, along with equity market overvaluation that rivals only the 1929 and 2000 extremes on reliable valuation measures, the brazenly experimental policies of central banks have amplified the sensitivity of the global financial markets to economic disruptions and shifts in investor risk aversion. 

The Fed has insisted on slamming its foot on the gas pedal, refusing to recognize that the transmission is shot. So instead, the fuel is instead just spilling around us all, waiting for the inevitable match to strike. We can clearly establish that activist monetary policy - deviations from measured and statistically-defined responses to output, employment and inflation - have had no economically meaningful effect, other than producing a repeated spectacle of Fed-induced, speculative yield-seeking bubbles. 

Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)

Negative interest rates could, if filtered through into deposits in any significant way, lead people to prefer the banknote to the deposit. That used to be called a bank run.

"Policy Singularity" refers to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in Bernanke’s famous helicopter speech. Briefly, the steps [taken by central banks] included quantitative easing; effectively pegging the yield curve; providing forward guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money.  

At this moment I still fret more about the outbreak of deflation than inflation, but such concerns would have to be abandoned if ‘helicopter money’ were implemented. The likelihood of their eventual implementation grows by the day as the failure of monetary policy becomes more evident. ‘Helicopter money’ will produce higher levels of broad money growth and inflation. Crucially, the state will not respond by lifting policy rates to control such inflation. Crucially, the state will not allow the yield curve to reflect rising inflation expectations or debts, particularly short-term debts, cannot be inflated away. Crucially, the state will not allow the private sector to gorge itself on credit, the natural reaction when inflation is higher than interest rates. ... This analyst meets few investors who don’t see that financial repression, the process through which the state manipulates the yield curve to below the rate of inflation, is the policy of choice for the developed world.

A summary of the critique of Unconventional Monetary Policy would include the following points:

1. There is little evidence (according to the BIS and others), that the UMP implemented since the Great Financial Crisis has provided a significant, lasting boost to either economic activity or inflation.
2. There is strong evidence that UMP has had a significantly inflated real and financial asset prices. This has contributed to the widening inequality of income and wealth.
3. Even if there are short term benefits of UMP, these are subject to diminishing returns and raise the risk of fuelling speculative bubbles. When such bubbles burst, the dislocations tend to feed through to the real economy, possibly triggering recession and/or deflation. 
4. Increasingly aggressive UMP narrows the room to maneuver of central banks and risks leaving them with limited policy choices for dealing with the next recession.
5. When the next downturn comes, central banks will be under political pressure to experiment with even more dangerous forms of UMP, including helicopter money (money financed fiscal stimulus).
6. Central banks' independence is reduced as monetary policy becomes the servant of fiscal policy and the objective of targeting inflation gives way to the imperative of financial repression as the government requires that interest rates be held below the rate of inflation so that government debt can be inflated away.
7. Breakdown of faith in UMP threatens central bank credibility and legitimacy.

What is the Future of UMP?

Just because thoughtful people outside of central banks are losing faith in UMP does not mean that the decision-makers of the major central banks are planning to change their approach to monetary policy. On the contrary, it seems that advocates of UMP are committed to taking even more aggressive actions if their targets for economic growth and inflation continue to be unmet.

The central bankers and academics who gathered at Jackson Hole, perhaps anticipating and responding to the growing criticism of UMP, made the theme of their symposium "Designing Resilient Monetary Policy Frameworks for the Future". Fed Chair Janet Yellen left little doubt that, in her opinion, UMP will play an important and possibly increased role in future monetary policy. In the event that the current expansion falters and the economy moves toward a recession, Yellen suggested that the tools of UMP would be resorted to once again: 

In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.

Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed's policy toolkit. ... That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.

On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.

In fact, Chair Yellen while solidly behind UMP measures adopted to date, was far from the most enthusiastic UMP advocate at Jackson Hole. Professor Marvin Goodfriend of Carnegie-Mellon University argued that, "It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions". The aforementioned Christopher Sims called for helicopter money financed fiscal stimulus as follows, "What is required is that fiscal policy be seen as aimed at increasing the inflation rate, with monetary and fiscal policy coordinated on this objective". Finally, Bank of Japan Governor Kuroda, who has overseen the most aggressive UMP to date, has no qualms about pushing ahead even further,

Looking ahead, the Bank of Japan will continue to carefully examine risks to economic activity and prices at each monetary policy meeting and take additional easing measures without hesitation in terms of three dimensions -- quantity, quality, and the interest rate -- if it is judged necessary for achieving the price stability target. QQE with a Negative Interest Rate is an extremely powerful policy scheme and there is no doubt that ample space for additional easing in each of these three dimensions is available to the Bank. The Bank will carefully consider how to make the best use of the policy scheme in order to achieve the price stability target of 2 percent, and will act decisively as we move on.

The Risks That Lie Ahead

With a developing professional view that UMP has gone too far, is subject to diminishing returns, and that short term gains from such policies are likely to give way to long term pain, there are significant risks to both the economy and financial markets no matter what path central banks decide to pursue. 

With the US economy having performed relatively well in the disappointing global expansion since the GFC, the Fed is in the strongest position to begin to remove unconventional monetary stimulus. Indeed, the Fed has already begun to do so by tapering quantitative easing, by lifting the policy rate by 25 basis points last December, and by providing forward guidance that the policy rate would continue to rise. However, each of these steps have caused corrections in global markets for risk assets and sharply increased volatility. The greatest volatility has come in China and other highly-geared emerging markets as the promise of tighter US financial conditions has spilled over into tighter global financial conditions. In response to this volatility and to slowing economic growth, the Fed has pushed back the timing of it plans for hiking the policy rate and eventually reducing the size of its' balance sheet.

Meanwhile, in an environment of slowing global growth and deflationary pressures, the adoption of negative policy interest rates, as well as continued large scale purchases of government bonds, by the BoJ and the ECB have pulled global bond yields down. At the low point in global bond yields, as much as US$13  trillion of government bonds had negative yields. Despite the Fed's intentions to reduce monetary stimulus, US bond yields fell to near record lows. In Canada, where the BoC has been sitting on its hands for over a year, the effect of foreign central banks' UMP has pushed bond yields to new lows, with the 10-year Canada bond yield falling below 1%. 

The fall in global bond yields has had three effects: it has reduced mortgage borrowing costs which has boosted prices and encouraged speculative activity in housing markets; it has caused investors to reach for yield in risky investments; and it has encouraged even highly-indebted governments to relax fiscal discipline by boosting debt-financed infrastructure spending plans.  

As consumer, corporate and government debt all continue to grow faster than nominal GDP, it becomes increasingly dangerous for central banks to remove monetary accommodation. Monetary policy increasingly becomes hostage to the need for financial repression, that is for interest rates to be pegged below the rate of inflation so that debt can be inflated away. Inflation targeting becomes less attainable and politically less popular.

Pushing further into unconventional monetary policies, say by moving towards "helicopter money", also known as central bank financed fiscal stimulus, might provide some short-term gain (as has resulted from other less drastic forms of UMP), it is also likely to result in even more long term pain.

Global ETF Portfolios for Canadian Investors: 2Q16 Review and Outlook

The stay-at-home strategy continued to perform well in 2Q16. The major forces that drove markets in 2015 have reversed in the first half of this year. Crude oil prices have rebounded and the monetary policy divergences between the US Fed and the Bank of Canada have narrowed.

The price of WTI crude oil, which began the year at US$37 per barrel and touched a 12-year low of just over US$26/bbl in February, then rallied back to finish 2Q16 at US$48/bbl. On the monetary policy front, the Fed, which had contemplated as many as four policy rate hikes in 2016, is now not expected to raise rates even once. The BoC, after anticipating the Liberal government's promised fiscal stimulus, went on hold in January and remains firmly on hold. The BoC decision to stand pat, combined with the Fed backing off on tightening, sparked a 12% rally in the Canadian dollar from the January low of 68.6 US cents to 76.8 cents by the end of March. After rallying further to test the 80 cents level in early May, the Canadian dollar fell back at the end June to 77.4 cents, amid risk aversion related to Brexit and signs that Canada's real GDP growth had stalled in 2Q. 

The rise in crude oil prices combined with the 0.7% gain in the Canadian dollar in 2Q16 provided tailwinds for stay-at-home portfolios while unhedged global ETF portfolios were able to recoup some of their losses sustained in the first quarter. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 3.7% in Canadian dollars. All of the unhedged Global ETF portfolios that I track in this blog posted gains for 2Q16. Since we began monitoring at the beginning of 2012, however, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio. 

Global Market ETFs: Performance for 2Q16

In 2Q16, with the USD depreciating 0.7% against the CAD, global ETF returns favored commodities and bonds. In CAD terms, 17 of the 19 ETFs we track posted positive returns, while 2 ETFs posted losses for the quarter. The chart below shows 2Q16 returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainer in 2Q16 was the commodity ETF (GSG) which returned 11.8% in CAD terms. The Gold ETF (GLD) returned 6.8%, while the Canadian long bond ETF (XLB) returned 5.3% in CAD terms. Other ETFs with strong returns for the quarter included Emerging Market Bonds (EMB) 4.9%; US High Yield Bonds (HYG) 4.5%; and Canadian equities (XIU) 4.2%.

The worst performers, were the Eurozone equity ETF (EWJ) and the Eurozone equity ETF (FEZ), which returned -4.4% and -0.3%, respectively in CAD terms. 

For 2016 year-to-date, the best performing ETFs in CAD terms were gold, the Canadian long bond and the Canadian equity ETF. The worst year-to-date performers were Eurozone, Japan (EWJ), US small cap (IWM), and US large cap equities (SPY).   

Global ETF Portfolio Performance for 2Q16

 In 2Q16, the Global ETF portfolios tracked in this blog all posted positive returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the USD hedged portfolios performed better for a second consecutive quarter.  

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 3.7% in 2Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 2Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 3.8% in CAD terms if USD-unhedged and had an even better gain of +5.1% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 2.9% if USD-unhedged and 3.4% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 1.4% in CAD terms when USD exposure was left unhedged, and 1.9% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 1.9% if unhedged and 2.2% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio has been a solid performer, returning 6.4% ytd, outgunning all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 11.2% in CAD terms.

Looking Ahead

The key market events of the first half of 2016 that influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that the Fed is unlikely to raise rates in 2016; the BoC's decision to eschew further easing; and the improving balance between global supply and demand for crude oil.  These events occurred against a backdrop of further downward revisions to global growth expectations and significant geopolitical uncertainty.

After rising at a 2.4% annualized pace in 1Q, Canada's growth likely stalled in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. Early indications for US growth, based on the Atlanta Fed's GDP Now forecast, point to 2.4% growth for US real GDP in 2Q, after just 1.1% in 1Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.5% in June from 1.9% in December and for the US to 1.7% from 2.4%.

Outside Canada and the US, growth prospects have also cooled. The UK real GDP forecast for 2016 has been cut to 1.5% in the wake of Brexit from 2.4% six months ago. Eurozone growth expectations have been marked down to 1.6% from 1.8%. Japan's growth now expected to reach only 0.7%, down from 1.1%. The sharpest cuts in expectations are for emerging market economies, with 2016 growth expectations down to 3.8% from 5.2%.

Meanwhile, Fed Chair Janet Yellen's message has been clear that the Fed will proceed cautiously with tightening, especially in light of the uncertainty trigged by the Brexit vote in the UK. In Canada, with substantial increases in government spending announced in the federal budget providing second half stimulus, the Bank of Canada is signalling that it will remain on hold for some time.  

At the end of March, we said "A sharp decline in worldwide oil and gas exploration and development spending suggests that crude oil production growth will slow, perhaps bringing global oil demand and supply into better balance as 2016 unfolds". That process continued through 2Q16, lifting crude oil prices to test US$50/bbl just before the Brexit vote. The rise in prices has halted the sharp decline in the North American rig count, but energy investment intentions continue to ebb, especially in Canada. Now that oil prices have recovered as seasonal demand for gasoline has hit its high point, the question is whether the crude oil price gains witnessed through 1H16 can be sustained, against a backdrop of sluggish global growth. 

This leaves markets in a similar position to where they were at the beginning of 2016. Equity market valuations remain stretched. Government bond market valuations are even more stretched as US and Canadian 10-year bond yields have fallen to new lows, while German, Swiss and Japanese 10-year yields are all negative.

The declines in global bond yields are a reflection of growth disappointments around the world and the market's assessment that this will result in more accommodative monetary policies than previously thought. Monetary ease has pushed up prices of gold and other commodities and has supported equity prices. We are living in an upside down world in which growth disappointments seem to lift financial asset prices because investors expect that weak growth will spur even more accommodative monetary policy. 

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of geopolitical risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.