tag:blogger.com,1999:blog-33389836382348951442024-03-14T04:18:58.358-07:00Ted Carmichael Global MacroTC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.comBlogger84125tag:blogger.com,1999:blog-3338983638234895144.post-82363467966339551822022-02-10T12:02:00.003-08:002022-02-10T12:19:40.351-08:00What Does the CPI Measure? The Case of Housing and Cars<p><span style="font-size: large;">Ask anyone if there is an inflation problem and they will likely say, "Well Canada's CPI is up 4.8% in December 2021 and that's the highest since 1991." Editorialists will say such things as "the cost of living is out of control" and support their argument by pointing to the rate of increase of the Consumer Price Index.</span></p><p><span style="font-size: large;">When I was downloading some CPI data from Statistics Canada I noticed this footnote:</span></p><blockquote><p><span style="font-size: large;"><b><i>The Consumer Price Index (CPI) is not a cost-of-living index.</i></b> The objective behind a cost-of-living index is to measure changes in expenditures necessary for consumers to maintain a constant standard of living. The idea is that consumers would normally switch between products as the price relationship of goods changes. If, for example, consumers get the same satisfaction from drinking tea as they do from coffee, then it is possible to substitute tea for coffee if the price of tea falls relative to the price of coffee. The cheaper of the interchangeable products may be chosen. We could compute a cost-of-living index for an individual if we had complete information about that person's taste and spending habits. To do this for a large number of people, let alone the total population of Canada, is impossible. For this reason, regularly published price indexes are based on the fixed-basket concept rather than the cost-of-living concept.</span></p></blockquote><p><span style="font-size: large;">So, it's not a cost of living index. I thought that I'd better go to the Bank of Canada website to see what the Bank says because, after all, they target keeping CPI inflation at 2%. So this is from the BoC's website: </span></p><blockquote><p><span style="font-size: large;">The CPI is a simple and familiar measure of price changes, or inflation. Employers use it to make cost-of-living adjustments in wages and salaries. Governments use it to adjust income taxes and social benefits such as the Canada Pension Plan and Old Age Security.</span></p></blockquote><p><span style="font-size: large;">OK, so now I'm confused. It's not a cost of living index, but the Bank of Canada says employers and governments use it as a cost of living index.</span></p><p><span style="font-size: large;">I know some of the history. When inflation was out of control in the 1970s, there was lots of talk about a wage-price spiral. Prices were rising fast, so workers often went on strike and bargained for higher wages. When higher wages were granted to cover the rising cost of living, producers of goods and services raised their prices and a wage price spiral ensued. During a period of high inflation, employers and governments come under pressure to increase wages and government benefits. This was especially true for programs and wages that were indexed to the CPI. Some economists then argued that the CPI was overstating inflation and the rise in the cost of living. In the US, the <a href="https://en.wikipedia.org/wiki/Boskin_Commission"><span style="color: #b45f06;">Boskin Commission</span></a> recommended a variety of changes to way inflation was measured to reduce what was viewed as an "upward bias" in the CPI. One of the changes was to introduce hedonic pricing for some items in the CPI to try to capture the effects of quality change. Anyway, the recommendations were adopted by many countries, including Canada, and this had the effect of dampening inflation as measured by the CPI.</span></p><p><span style="font-size: large;">So today, even with these changes made to the CPI, Statistics Canada says it is not a cost of living index, but it is widely used as a cost of living index to adjust some wages as well as many public and private pension payments.</span></p><p><span style="font-size: large;">These days, the complaint most often heard, at least form the general public, is that the CPI understates inflation and the rising cost of living that they are experiencing. Most of these complaints come from looking at the way housing and automobiles are treated in the CPI. We hear from the real estate industry that house prices were up 26.6% from a year earlier in December 2021, but the CPI measure of housing (what they call "owned accommodation) is only up 5.8%. What gives? We hear from the auto industry that because of a global shortage of microchips, new cars can't be completed and their prices are rising sharply. We hear from the used car industry that the shortage of new cars and trucks has pushed consumers into buying used vehicles and their prices are soaring by as much as 30-40%. But Canada's CPI for motor vehicle purchase was up just 7.2% in December, while the US CPI for new and used vehicles was up 21%. What gives? </span></p><p><span style="color: #b45f06; font-size: large;">Housing Prices in the CPI</span></p><p><span style="font-size: large;">Statistics Canada has heard these complaints before. In 2017, during an earlier spike in house prices when the CPI was not tracking what people were seeing happening to house prices, StatCan published a <a href="https://www150.statcan.gc.ca/n1/pub/62f0014m/62f0014m2017001-eng.htm"><span style="color: #b45f06;">note</span></a> on the measurement of housing prices in the CPI. Here are some excerpts from the note:</span></p><blockquote><p><span style="font-size: large;">There are many approaches to processing owned accommodation: payment, net acquisition, rental equivalence, user cost, and exclusion altogether. Depending on the main purpose of its CPI (indexation, deflation of expenditures or incomes, monitoring monetary policies), each statistical agency adopts a version of one of these approaches.....</span></p></blockquote><p></p><blockquote><span style="font-size: large;">The “net acquisition” approach consists of treating owner-occupied dwellings like all other durable goods in the CPI, which means attributing all dwelling purchase costs to the acquisition period, even if the useful life of the dwelling spans well beyond this period. For this option, net dwelling purchases in the reference year would be used as the expenditure weight for owned accommodation. <i><b>Since it provides the possibility of instantly showing the impact of dwelling price changes on the CPI, the “net acquisition” approach has interesting characteristics for measuring price inflation and monitoring monetary policy.</b></i> However, since it does not take into account the stream of services generated by the owned accommodation across time, it is less favoured for a CPI that is used primarily for indexation...</span></blockquote><blockquote><p><span style="font-size: large;">... there is a general consensus that <i><b>the acquisition approach is the most suitable for handling owned accommodation, when the primary use is tracking inflation in the housing market</b></i>, since this approach makes it possible to automatically show the impact of changes in dwelling prices... </span></p></blockquote><blockquote><p><span style="font-size: large;">On the other hand, an owned accommodation index like the one adopted by the Canadian CPI, based on the user cost approach does not seek to measure changes in dwelling prices. Its purpose is to determine changes in the cost of using a stock of dwellings. This makes it sensitive to past movements in housing prices, as well as imputed costs such as depreciation. <i><b>Those wishing to use the CPI as an indicator of inflation in the housing market must be aware of the inherent limitations of such an approach, and should not expect it to produce an index that automatically tracks movements in dwelling prices. </b></i></span></p></blockquote><p><span style="font-size: large;">Now, I'm getting more confused. StatCan says the CPI is not a cost of living index. But when it comes to choosing a method of measuring housing prices, they choose a method which they judge is more appropriate for (cost-of-living) indexation. They reject a method which is "most suitable... for tracking inflation in the housing market" and "monitoring monetary policy".</span></p><p><span style="font-size: large;">Well, what difference does it make? Suppose, that we equally-weighted Statistics Canada's New House Price Index (up 11.7%) and the Teranet House Price Index for existing homes (up 15.5%) and used the result (up 13.2%) in the CPI instead of StatCan's user cost approach to measuring owned accommodation prices (up 5.8%). Owned accommodation has a weight of 19.2% in Canada's CPI, so using StatCan's method, it contributes (.192 x 5.8%) or 1.1 percentage points to the December inflation rate of 4.8%. If we used the equally weighted increase in new and existing house prices (13.2%), the contribution of owned accommodation would be (.192 x 13.2%) or 2.6 percentage points to the CPI inflation rate. </span></p><p><span style="color: #b45f06; font-size: large;">Motor Vehicles in the CPI</span></p><p><span style="font-size: large;">Prior to the pandemic, most people, including most economists probably thought that the price of motor vehicles was treated the same in measuring both the Canadian and US CPI. But they are not. This became evident when US inflation started spiking in the spring of 2021 and one of the leading causes was the sharp rise in prices of used vehicles. When that happened, I for one, did take the trouble to look at Canada's CPI breakdown to see what was happening to used vehicle prices in Canada. But there was nothing there. A phone call and an email to StatCan returned the information that, "No, Canada's CPI does not include used cars, only new cars." </span></p><p><span style="font-size: large;">So then one has to look for industry information to see what is happening with used vehicle prices. The US has the <a href="https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html"><span style="color: #b45f06;">Manheim index</span></a> which provides a clear picture that used car prices have surged in the US and most of this surge is being picked up in the US CPI. Manheim does not have an index for Canada, but some time spent searching the web shows that <span style="color: #b45f06;"><span style="caret-color: rgb(180, 95, 6);"><a href="https://www.cargurus.ca/Cars/price-trends/">CarGurus</a></span></span> has an estimate that in Canada, used vehicle prices are up 35-40%. Well, how important could that be, you might ask?</span></p><p><span style="font-size: large;">Google is a wonderful tool for getting answers. I'm not a statistician and the following comments might be questioned by an expert, but here goes.</span></p><p><span style="font-size: large;">First, how important are used vehicle sales? Well, in the US new vehicle sales in 2021 were about 15 million units. Used vehicle sales were 40.1 million. Almost three times as many used vehicles are sold to consumers compared to new vehicles. </span></p><p><span style="font-size: large;">The average price of new vehicles in the US rose to a record US$47,000 in December 2021 according to Kelly Blue Book and increase of 15.2%. The US CPI measured US new vehicle prices to be up 11.8% in December. The difference is probably mostly accounted for by the "hedonic quality adjustment" done for the CPI. But if you are a consumer who bought a car, the average price was up 15.2% as the Blue Book says.</span></p><p><span style="font-size: large;">The average price of used vehicles in the US rose to a record US$28,200 according to Cox Automotive in December 2021, up by a stunning 46.6% from year earlier. The US CPI measured used vehicle prices to be up 37.3% in December. </span></p><p><span style="font-size: large;">Based on the US CPI measures, new and used vehicles contributed 1.5 percentage points to US CPI inflation of 7.1% in December. If the industry measures of price increases were used the contribution would have been 1.9% and total inflation would have been 7.5%.</span></p><p><span style="font-size: large;">In Canada, new vehicle sales were 1.66 million in 2021. There is no industry data that I could find on Canadian used car sales, but since the auto markets in Canada and the US are very similar, one could estimate that used vehicle sales in Canada are probably in the 4 to 4.5 million range. The best guide the used vehicle prices is the CarGurus price index which recently showed a 34% increase over a year ago, lower than the US industry estimate, but quite close to the US CPI estimate.</span></p><p><span style="font-size: large;">Based on Canada's CPI measures, the increase in new vehicle prices added 0.45 percentage points to Canada's CPI inflation of 4.8% in December 2021. Of course, used vehicle prices contributed zero percentage points because they are not included. So, even though the auto markets in Canada and the US experienced very similar conditions in 2021, vehicle prices contributed just .45% to Canada's inflation rate compared with 1.5% in the US. Thus, it would seem that Canada's CPI is probably understated by at least 1 percentage point due to the exclusion of used car prices. </span></p><p><span style="font-size: large;">If used vehicle prices had been included, using the CarGurus estimate, and if Blue Book prices had been used for new cars (rather than the hedonically quality-adjusted estimates used by Statistics Canada) then the contribution of new and used vehicle prices to Canada's CPI could have been as much as 1.7 percentage points (instead of 0.45 pct pts).</span></p><h2 style="text-align: left;"><span style="color: #b45f06; font-size: large;">Concluding Comments</span></h2><p><span style="font-size: large;"><span>A lot of people are experiencing inflation differently from the official statistics. In the 1970s, the argument was that the CPI was overstating inflation. Today, it feels like the CPI is significantly understating inflation. Statistics Canada admits that the method it uses to measure owned accommodation prices is not the best measure for gauging inflation and for monetary policy purposes. The Bank of Canada does not acknowledge this. The exclusion of used vehicle prices from calculation of Canada's CPI is clearly understating inflation as it is experienced by consumers. If we used easily understandable alternate measures of prices for houses, CPI inflation would be about 1.5 percentage points higher. If we </span><span>included used vehicles and </span><span>used industry estimates for vehicle price increases would be as much as 1.7 percentage points higher. Just adjusting the two components, which make up about 25% of the CPI, would boost our estimate of actual inflation being experienced on average by actual people by something between 2.5 and 3.2 percentage points. That would put December's CPI inflation not at 4.8%, but somewhere between 7.3% and 8.0%. That is probably closer to how consumers are experiencing inflation today than the official estimate. </span></span></p><p><span style="font-size: large;"><span>Despite a warning from Statistics Canada that the CPI is not a cost of living index, it is widely used for cost of living adjustments. The Bank of Canada continues to express optimism that once supply chain pressures ease, inflation should drift back down toward the 2% target, but consumers can't be blamed for being skeptical. Despite commentators suggesting that Canada's inflation is not as bad as in the US, it probably is as bad or worse.</span> </span></p><blockquote><span style="font-size: large;"> </span></blockquote><p></p><blockquote><p><span style="font-size: large;"> </span></p></blockquote><blockquote><p><span style="font-size: large;"> </span></p></blockquote><blockquote><p><br /></p></blockquote>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-10040796788061145452020-04-15T18:57:00.000-07:002020-04-16T05:42:41.389-07:00Update on Economic Projections from the Bank of Canada<span style="font-size: large;">This is a follow-up on my post, <a href="http://tcglobalmacro.blogspot.com/2020/03/canada-post-covid19.html" target="_blank"><span style="color: #b45f06;">Canada Post Covid19</span></a>, from March 31. I concluded that post with the following:</span><br />
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<span style="font-size: large;"><i>Bank of Canada Governor Poloz said that the lowered private sector forecasts he was seeing were little more than arithmetic and promised to unveil new projections on April 15th from the Bank of Canada's forecasting team, which he described as "the best there is". He suggested that more than just doing arithmetic, the Bank of Canada's forecasters would take account of confidence effects and how behavior might change in the post-Covid19 world. One suspects that the Bank will provide a range of scenarios based on differing assumptions about the course of the Covid19 pandemic and the likely economic repercussions of a shorter or longer crisis. </i></span></blockquote>
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<span style="font-size: large;"><i>Many questions are not answered, or even addressed, in these forecast revisions. Will government support programs and a huge increase in deficit spending prevent corporate defaults and a permanent destruction of economic capacity. If debt defaults are too large, will that tigger persistent higher unemployment and unleash deflationary forces? Will Canada's highly productive energy industry be able to recover when government policies are tilted toward "phasing out" fossil fuels? Will financial markets take in stride the coming huge spike in Canada's federal debt-to-GDP ratio, or will investors demand a higher credit risk premium for a country which already has very high levels of household and corporate debt? Will the Bank of Canada's policy interest rate setting stay at the effective lower bound indefinitely, and if so, will bond markets anticipate higher inflation and bond yields? Perhaps the Bank of Canada's crack forecasting team will shed some light on these questions. But probably not.</i></span></blockquote>
<span style="font-size: large;">Having read the Bank of Canada's April <i><a href="https://static.bankofcanada.ca/uploads/pdf/mpr-2020-04-15.pdf" target="_blank"><span style="color: #b45f06;">Monetary Policy Report</span></a></i>, I must admit that I am not surprised that most of the questions posed above were not addressed. As noted in the <i>MPR</i>, the future course of Covid19 is still too uncertain to make projections with any precision. As I suspected, the BoC chose to provide a range of scenarios based on differing assumptions about the course of the pandemic and the eventual relaxation of containment measures. I was surprised, however that while the <i>MPR</i> did provide charts showing a range of plausible projections for the level of real GDP and CPI inflation, it did not provide any numerical projections.</span><br />
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<span style="font-size: large;">However, from the charts provided by the <i>MPR</i>, we can extract the Bank's most optimistic and most pessimistic projections and they are very surprising. </span><br />
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<span style="font-size: large;">First, a digression. When I started my career as an economist straight out of graduate school in 1977, I went to work at The Conference Board of Canada. At the time, the Conference Board had Canada's only private sector quarterly econometric model forecast. The Board had a very strong team of forecasters and its' quarterly forecasts were presented at large conferences for members, quite often with up-and-coming economists from the Bank of Canada in attendance. I worked at the Board from 1977 to 1980, helping out with the forecast and publishing a number of research reports. These forecasts and research reports had lots of charts and graphs. We had a big mainframe computer that could print out the tables with all of the forecast numbers, but computer graphic printers had not yet been perfected. Instead, we had a chart room, which employed numerous graphic artists who toiled all day grinding out the charts using graph paper, rulers, light tables and all the many tools of their trade. Remembering those days, one can use a ruler and a pencil and reverse engineer the Bank of Canada's charts in the <i>MPR</i> to come up with the data points for their most optimistic and pessimistic scenarios.</span><br />
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<span style="font-size: large;">When one goes to the trouble to do that, one gets a surprise, as shown in the chart below. In the chart, I compare the BoC's projections with the pre-Covid19 path of potential GDP and with forecasts made in late March by TD Economic Research and by the Parliamentary Budget Office which were shown in my previous post.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1RTDDGuklIMzzaSSDUSwqf40gzyX95Jc1_DJdwF2KY8E7enLqZ0hWc0tAmrgDq1nt96UxwzpA9PnszSLOz02uHMcTBq2nOy4EQJynupBN7I6tONZTf1NpxbwTeH7pG5EZ9-onH73BLjE/s1600/BoC+Covid+Projections.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="756" data-original-width="1137" height="424" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1RTDDGuklIMzzaSSDUSwqf40gzyX95Jc1_DJdwF2KY8E7enLqZ0hWc0tAmrgDq1nt96UxwzpA9PnszSLOz02uHMcTBq2nOy4EQJynupBN7I6tONZTf1NpxbwTeH7pG5EZ9-onH73BLjE/s640/BoC+Covid+Projections.png" width="640" /></span></a></div>
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<span style="font-size: large;">The surprising thing about the BoC projections is that even the Optimistic projection shows a far deeper plunge in real GDP in the first half of 2020 than the worst private sector forecasts. In the <i>MPR</i> press conference Governor Poloz said that he thought the Optimistic projection was attainable if containment measures started being relaxed in late May or early June. The Pessimistic projection, which contemplates a later relaxation of containment measures, shows the level of real GDP collapsing by more than three times as much as either the worst private sector forecast or the forecast used by the Parliamentary Budget Office when it projected a C$182 billion deficit for FY2020-21.</span><br />
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<span style="font-size: large;">The BoC's Optimistic real GDP projection works out to be a contraction of about 6.5% in 2020 followed by about a rebound to about 8.5% growth in 2021. The average forecast from the economists of Canada's big banks in early April was for a contraction of about 4% in 2020 followed by a slightly better than 4% rebound in 2021. For comparison, the latest IMF forecast for Canada calls for a contraction of 6.2% in 2020 (very similar to the BoC's optimistic scenario) followed by a 4.2% rebound in 2021 (very similar to the private sector bank forecasts). The BoC's Pessimistic projection is horrendous, calling for a 19% contraction in 2020, followed by a 4% rebound in 2021. </span><br />
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<span style="font-size: large;">Another way to view the Bank's projections is to convert them into projections of the output gap, i.e. the gap between projected GDP and potential GDP, which was assumed to be growing at about 1.7% before Covid19. The chart looks similar, but the scale shows that while TD Economics and the PBO expected economic activity to fall about 10% below previous estimates of its' potential, the BoC expects real GDP to fall, optimistically, 15% or, pessimistically, 30% below potential before beginning a quick or slow recovery. In the Optimistic projection, real GDP recovers to near full capacity by the end of 2021. In the Pessimistic projection, real GDP would still be almost 15% below its pre-Covid19 potential at the end of 2021, an outcome which would surely be called a depression. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtptEBmo_5Vnjng143qWWKo7mXsBaiSJgCelJu4nFThXBmXoJOZ-5fjHATkXxJhKkSkRXV1gxueygu8fpCVyWF9KnFu6RRQsa4_Z4_Pu-5QFilwPgoO97e0paXI4LhE9Z1dGcfANpztDQ/s1600/BoC+Output+Gaps+Covid19.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="787" data-original-width="1214" height="414" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtptEBmo_5Vnjng143qWWKo7mXsBaiSJgCelJu4nFThXBmXoJOZ-5fjHATkXxJhKkSkRXV1gxueygu8fpCVyWF9KnFu6RRQsa4_Z4_Pu-5QFilwPgoO97e0paXI4LhE9Z1dGcfANpztDQ/s640/BoC+Output+Gaps+Covid19.png" width="640" /></span></a></div>
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<span style="font-size: large;">No wonder the Bank of Canada decided not to publish numerical projections! Doing so would probably have been a shock to the already battered confidence of Canadian businesses and consumers. It would also have implied a much larger budget deficit than that projected by the Parliamentary Budget Office. </span> <br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com3tag:blogger.com,1999:blog-3338983638234895144.post-84948294666286402392020-03-31T17:18:00.000-07:002020-03-31T17:18:41.019-07:00Canada Post-Covid19<span style="font-size: large;">Worldwide confirmed cases of Covid-19 ramped up dramatically in March. As the case count grew, governments around the world imposed draconian, but necessary, public health restrictions which have had the effect of shutting down large swaths of the global economy. This has caused a scramble by economists to revise their forecasts from what was a benignly boring view at the beginning of the year that nothing particularly interesting would happen to the economy in 2020.</span><br />
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<span style="font-size: large;">In February, when Covid-19 was mainly a Chinese phenomenon, that led to the lockdown of Wuhan and Hebei Province, most economists forecast that the virus would have little impact on global growth and that China's economy would slump in 1Q19 but snap back in V-shaped recovery in 2Q19. However, as the virus spread exponentially across the globe in March, economists began to take it seriously and to take down their growth forecasts and consider the possibilities of U-shaped or even L-shaped recoveries. By mid-month, some economists declared a global recession. By month-end, a debate was developing about whether it would be a Recession or a Depression.</span><br />
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<span style="font-size: large;">For their part, Canadian economists began adjusting their forecasts in early March and progressively downgraded the growth outlook as the month wore on. The chart below shows how forecasts for Canada's real GDP have changed since late February.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWUW9pQyGpcRLKYdkzZMEmHriIgNWn_gJ7RifQvJdSCygtZVO9tJhoBFfkRihi6Wbj8_qZrPtCRHAkDG7og2y06zBD1PSTjAjgSavqlsBrPVOorJNDmpH0G-mvLB981l-2f_TDHhiUEjw/s1600/Canada+Real+GDP+Forecast+Revisions.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="741" data-original-width="1089" height="434" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWUW9pQyGpcRLKYdkzZMEmHriIgNWn_gJ7RifQvJdSCygtZVO9tJhoBFfkRihi6Wbj8_qZrPtCRHAkDG7og2y06zBD1PSTjAjgSavqlsBrPVOorJNDmpH0G-mvLB981l-2f_TDHhiUEjw/s640/Canada+Real+GDP+Forecast+Revisions.png" width="640" /></span></a></div>
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<span style="font-size: large;"> </span><br />
<span style="font-size: large;">The Chart shows real GDP in level terms; it was C$2.1 trillion seasonally adjusted at annual rates in 4Q19. On February 21, the economists at my old employer, JP Morgan, had a close-to-consensus forecast that the economy would grow steadily, if not robustly, at about its' potential rate of 1.7%. By March 13, JPM had downgraded the forecast to show a moderate recession, with growth contracting at annual rates (ar) of -1.5% in 1Q20 and -2.5 in 2Q20, followed by a rebound in growth to about a 3%ar in the second half of the year.</span><br />
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<span style="font-size: large;">Two weeks later, on March 27, JPM had reassessed the damage and forecast contractions of -5.5%ar and -18.5%ar in the first two quarters of the year, followed by growth averaging 9%ar in the second half. For comparison, Bank of Montreal (BMO) Economics on March 27 forecast contractions of -6.5% and -25%ar in 1Q and 2Q20, followed by a rebound at a stunning 30%ar in 3Q20 and 4% in 4Q. TD Economics made a similar forecast on March 25, but didn't expect as fast a rebound in growth as BMO. </span><br />
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<span style="font-size: large;">The convention of stating growth at annual rates confuses people by exaggerating the weakening of the economy. The reality, for those who are not growth afficionados, is that BMO, for example, is forecasting that seasonally-adjusted real GDP will contract by -1.7% in 1Q20 and by -7% in 2Q, followed by a 6.8% rebound in 3Q20 and 1% growth in 4Q20. This results in a full year contraction of real GDP of -3% in 2020. Forecasts for 2021 growth now stand at 2.7% for JPM, 3.5% for BMO and 3.7% for TD. It would be helpful and constructive for economists to stop reporting their quarterly forecasts at seasonally adjusted annual rates and just report the actual contraction of real GDP.</span><br />
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<span style="font-size: large;">This is not to minimize the hit to the economy, it is just to clarify what these economists are telling us. In fact, their arithmetic points to a very sudden and serious recession. The range of forecasts is fairly large, even though all of the forecasters expect the economy to be recovering by 3Q20. All of the forecasters are assuming that Covid19 cases will peak in 2Q and subside in a manner similar to that experienced in China or South Korea. If new cases take longer to peak or if there is a resurgence of new infections in the autumn, the rebound in real GDP will be slower and take longer than in the current forecasts.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Even if the current forecasts are close to accurate, they point to a significant loss of real output and incomes. The output gap is forecast to widen to the 7-9% of GDP range in 2Q20. Real incomes will likely fall by even more as Canada's terms of trade have fallen sharply due to the drop in crude oil and other commodity prices. Even in the most optimistic forecast, real GDP will not return to its' potential by the end of 2021. BMO forecasts that even six quarters into the recovery, the output gap would still be almost 3% of GDP, while JPM and TD see the gap still at almost 4% of GDP. Forecasters seem to be suggesting that there Covid19 is causing a permanent loss of output and income and a downshift in the future path of the level of real GDP. </span><br />
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<span style="font-size: large;">While economists have spent considerable effort attempting to estimate the immediate hit to real GDP, they seem to have spent less time thinking about the impact of Covid19 on inflation. The chart below shows some of the latest inflation forecasts.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgEsDwLPRZJTtSY_VuD56T5HbDqpjU9pTGSMF83f2dkugYsJfUZOBJL5evQflZgaXLEkoyeodVMt9wa9d1bVjM_9Yc_e40fsA6Tzl1DzChXbdE3zVe_hGVnaU4TLVrYsch7thYwfWoRqIw/s1600/Canada+Covid19+Inflation+Forecasts.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="729" data-original-width="1089" height="428" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgEsDwLPRZJTtSY_VuD56T5HbDqpjU9pTGSMF83f2dkugYsJfUZOBJL5evQflZgaXLEkoyeodVMt9wa9d1bVjM_9Yc_e40fsA6Tzl1DzChXbdE3zVe_hGVnaU4TLVrYsch7thYwfWoRqIw/s640/Canada+Covid19+Inflation+Forecasts.png" width="640" /></span></a></div>
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<span style="font-size: large;">Before significant adjustments in forecasts were made, as illustrated by JP Morgan's February 21 forecast, the outlook was for CPI inflation to remain well behaved and to converge to the Bank of Canada's 2% target by the end of 2020 and to remain there through 2021. By March 27, all forecasters had built in a dip in inflation in 2Q20 followed by a steady return to the 2% target or slightly higher by the end of 2021. BMO projects the biggest dip in inflation to just 0.3% over a year ago in 2Q20, and despite their forecast of a sharp snapback in real GDP in 3Q20, still expects inflation to be just over 1%oya in 1Q21. Perhaps because they have been well trained by the Bank of Canada's projections, all forecasters expect inflation to converge to close to target within two years. Yet, as mentioned above, these forecasters still expect an output gap (excess capacity) of between 3 and 4% of GDP by the end of 2021. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Some forecasters may rationalize this return to target inflation despite a still sizable output gap by assuming that potential GDP estimates will be permanently reduced by the Covid19 crisis. It is not clear why this should be the case. The growth of the labour force is not likely to be affected unless the government indefinitely closes the border to immigration. And there is no reason to mark down potential estimates of productivity unless economists believe that Covid19 will a permanent depressing effect on capital investment. These outcomes are possible, but only likely if the economic shutdown lasts much longer than is assumed in current forecasts. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Bank of Canada Governor Poloz noted the lowered growth and inflation forecasts as the Bank cut its policy rate to the "effective lower bound" of 0.25% from 1.75% at the end of February. Poloz said that the lowered forecasts he was seeing were little more than arithmetic and promised to unveil new projections on April 15th from the Bank of Canada's forecasting team, which he described as "the best there is". He suggested that more than just doing arithmetic, the Bank of Canada's forecasters would take account of confidence effects and how behavior might change in the post-Covid19 world. One suspects that the Bank will provide a range of scenarios based on differing assumptions about the course of the Covid19 pandemic and the likely economic repercussions of a shorter or longer crisis.</span><br />
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<span style="font-size: large;">Many questions are not answered, or even addressed, in these forecast revisions. Will government support programs and a huge increase in deficit spending prevent corporate defaults and a permanent destruction of economic capacity. If debt defaults are too large, will that tigger persistent higher unemployment and unleash deflationary forces? Will Canada's highly productive energy industry be able to recover when government policies are tilted toward "phasing out" fossil fuels? Will financial markets take in stride the coming huge spike in Canada's federal debt-to-GDP ratio, or will investors demand a higher credit risk premium for a country which already has very high levels of household and corporate debt? Will the Bank of Canada's policy interest rate setting stay at the effective lower bound indefinitely, and if so, will bond markets anticipate higher inflation and bond yields? Perhaps the Bank of Canada's crack forecasting team will shed some light on these questions. But probably not. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-79513261109443304642020-03-01T20:19:00.000-08:002020-03-01T20:19:01.276-08:00Even before Covid-19 the Bank of Canada Needed to Ease<span style="font-size: large;">The rapid global spread of the Covid-19 virus and the precautionary health measures being taken in many countries to stem the pandemic have created turmoil in financial markets. Most global stock markets are in correction -- down more than 10% from their recent highs. Global bond yields have plunged -- the 10-year US Treasury yield touched a record low of 1.12% on February 28, before closing at 1.16%. The 10-year Canada bond closed at 1.13%, down from a recent high of 1.70% on November 2 and the lower than in January 2015 when the Bank of Canada last cut the policy rate. Commodity prices have plunged as global demand has cratered. The benchmark West Texas Intermediate (WTI) crude oil price has dropped 27.5% to $45.26 from $62.43, its recent high in early January. Western Canadian Select (WCS), Canada's benchmark crude price has fallen to $31.69 from a high of $58 in May 2018. The turmoil in asset markets is a reflection of repricing in highly liquid financial markets reflecting investor's expectations, based on current information, of how activity levels are being affected by containment efforts to halt the global spread of coronavirus.</span><br />
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<span style="font-size: large;">The spread of Covid-19 is creating a chain reaction of economic effects. The initial outbreak in China, which probably began in December but was not acknowledged until late January, led to public health measures which caused workers to stay away from work, travelers to stop traveling, and consumers to stay away from shops, restaurants and entertainment venues. Coal consumption fell 40% as factories were shut down. Supply chains that depend upon Chinese manufactured goods were interrupted. Shipping volumes dropped sharply. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Economists have been scrambling to monitor the contraction in economic activity. In the early days, many economists suggested the the impact would be minor, merely causing a slowdown in China's economic growth in 1Q19 that would be fully made up in a V-shaped bounce back in 2Q19. However, as February wore on, it became abundantly clear that the virus had not been contained. Outbreaks in other countries including Japan and South Korea, on passenger ships, and eventually further afield in Iran and Italy made it clear that Covid-19 had become a pandemic, even if the World Health Organization was reluctant to say so. Now, economic activity has stalled in Hong Kong, Singapore, Tokyo, Seoul and Milan. Countries around the world are warning their citizens to prepare for Covid-19 outbreaks. In Canada, the federal health minister has suggested that citizens put together survival kits to see them through the possibility of two weeks or more of self-imposed quarantine.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">As time has passed, economists have progressively cut their forecasts for 2020 economic growth and in many cases have acknowledged that a V-shaped rebound in 2Q19 is becoming much less likely as the virus continues to spread internationally.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">The Bank of Canada's Dilemma</span></h3>
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<span style="font-size: large;">In January, Bank of Canada Governor Stephen Poloz revealed that the Bank's forecast for growth of Canada's real GDP in 4Q19 had been cut to 0.3% at an annual rate from the October forecast of 1.7%. The Bank projected a modest rebound in 1Q20 growth to 1.3% and to about 2% in subsequent quarters of 2020. In releasing these projections along with a decision to leave the policy rate unchanged at 1.75%, Governor Poloz said,</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">All things considered, then, <span style="color: yellow;">it was Governing Council’s view that the balance of risks does not warrant lower interest rates at this time.</span> In forming this view, we weighed the risk that inflation could fall short of target against the risk that a lower interest rate path would lead to higher financial vulnerabilities, which could make it even more difficult to attain the inflation target further down the road. <span style="color: yellow;">Clearly, this balance can change over time as the data evolve.</span> In this regard, <span style="color: yellow;">Governing Council will be watching closely to see if the recent slowdown in growth is more persistent than forecast.</span> In assessing incoming data, the Bank will be paying particular attention to developments in consumer spending, the housing market and business investment.</span></blockquote>
<span style="font-size: large;">Since making this statement, real GDP growth in 4Q19 did match the BoC's anemic projection of 0.3% at an annual rate. Early data for 1Q20 has been mixed with housing starts, real exports and total employment modestly firmer in January but with total hours worked, the manufacturing PMI and real imports all down from the 4Q19 average. Activity levels in February will have been depressed by the rail and port blockades by activists protesting the Coastal Gas Link Pipeline. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Global growth forecasts for 1Q20 have been progressively marked down over the past few weeks as the spread of Covid-19 moved quickly and became an incipient pandemic that was likely to last longer and deal a bigger blow to global activity than originally thought.</span><br />
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<span style="font-size: large;">If the Bank of Canada was worried in mid-January, before the Covid-19 pandemic began, that the late-2019 slowdown in growth might be more persistent, there can be no doubt that the downside risks to both growth and inflation have increased substantially since then. </span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Why the BoC should be easing</span></h3>
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<span style="font-size: large;">Even before the spread of Covid-19 and the precautionary actions that are slowing global commerce, there was strong reason for the Bank of Canada to follow the lead of the US Fed and numerous other central banks since mid-2019 in cutting their policy rates.</span><br />
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<span style="font-size: large;">Since early May 2018, Canada's commodity prices have been falling. When commodity prices fall, Canada's terms of trade weaken as the prices of our exports fall relative to the price of our imports. Historically, the Bank of Canada has responded to sharp falls in commodity prices and the terms of trade by easing monetary conditions through a combination of lowering the policy rate and allowing the Canadian dollar to weaken against foreign currencies. The Bank last did this in early 2015 when crude oil prices collapsed. </span><br />
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<span style="font-size: large;">In the chart below, for the 2014-15 period, the commodity terms of trade, which I define as the Bank of Canada's commodity price index divided by the core CPI, is shown alongside the BoC's measure of Canada's nominal effective exchange rate (CEER). The CEER is shown against all currencies and also against all currencies excluding the US dollar.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLFGev-BLQO97YRWRQZzN0y4cuOd_5bTQaCFoExvHLrQn6PFuFcWFdRpx-vYJWVCcb-uxIpAcljvnsCSbtWJbYU8UOC_vOWmfLT_8tbv6zGnwwJJJfE1kVqcjfof8Y3TuU6RWKf2YQwDg/s1600/Cmdy+ToT+and+CEER+2018-20.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="685" data-original-width="1085" height="403" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLFGev-BLQO97YRWRQZzN0y4cuOd_5bTQaCFoExvHLrQn6PFuFcWFdRpx-vYJWVCcb-uxIpAcljvnsCSbtWJbYU8UOC_vOWmfLT_8tbv6zGnwwJJJfE1kVqcjfof8Y3TuU6RWKf2YQwDg/s640/Cmdy+ToT+and+CEER+2018-20.png" width="640" /></span></a></div>
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<span style="font-size: large;">As the chart clearly shows, the commodity terms of trade dropped sharply in late 2014 as world and Canadian crude oil prices collapsed. As this occurred, Canada's effective exchange rate weakened because of a weakening of the Canadian dollar versus the US dollar, while excluding the USD, the effective exchange rate actually strengthened until January 2015. In January, the Bank of Canada stunned market participants by cutting the policy rate, which triggered a sharp fall in the effective exchange rate, both including and excluding the USD. The weakening of the CAD helped cushion the blow of the oil price collapse on oil-producing regions of Canada and helped improve the export competitiveness of other sectors and regions of the economy.</span><br />
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<span style="font-size: large;">Now look at the same chart for the 2018-20 period. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEis4hK-1UA_mWD6Y5X4nWVFGpKFW8iqkOBHd5qUoMMPnLVIMUXGbUB1XHTMA5Ve3_YyNDx5sqSEEn6JwqnLWfnfuDiYCCld7YRImTHMRuPW9-ZHxFLhJFqzWpg8jDB9Bv5BGDB7P_EnDZk/s1600/Cmdty+ToT+and+CEER+2014-15.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="685" data-original-width="1068" height="410" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEis4hK-1UA_mWD6Y5X4nWVFGpKFW8iqkOBHd5qUoMMPnLVIMUXGbUB1XHTMA5Ve3_YyNDx5sqSEEn6JwqnLWfnfuDiYCCld7YRImTHMRuPW9-ZHxFLhJFqzWpg8jDB9Bv5BGDB7P_EnDZk/s640/Cmdty+ToT+and+CEER+2014-15.png" width="640" /></span></a></div>
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<span style="font-size: large;">Once again, the commodity terms of trade peaked in May 2018 before falling sharply in late 2018 as central bank tightening, led by the US Fed, raised recession fears. Slowing growth and the sharp fall in commodity prices, along with a melt-down of global equity markets, caused the Fed and other major central banks to reverse course by cutting their policy rates and, in some cases, adding liquidity by expanding their balance sheets through quantitative easing. The Bank of Canada was an outlier, choosing not to follow suit with rate cuts of its own. The result was that, despite a sharp weakening in commodity prices, Canada's nominal effective exchange rate appreciated. This not only made times more difficult for commodity producing sectors and regions, but also caused a deterioration in the export competitiveness of Canada's manufacturing exports at a time of stagnating global trade. The Bank of Canada, through this period, expressed concern about the risk that high household debt levels posed to financial stability. The BoC made a clear trade-off, attempting to constrain household borrowing, especially mortgage borrowing in Toronto and Vancouver, at the expense of Canada's commodity sector and other export oriented industries.</span><br />
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<span style="font-size: large;">Since the onset of Covid-19, commodity prices have renewed their decline. The commodity terms of trade have now weakened 27.5% since May 2018, half of the steep decline in 2014-15. The 2014-15, the 52% decline in the commodity terms of trade was cushioned by a depreciation of 22% against the USD, a depreciation of the nominal effective exchange rate of 15%, and an effective depreciation of 7.5% against non-US trading partners. The 27.5% decline of the commodity terms of trade since May 2018 has been accompanied by just a 1.6% depreciation against USD, but a 1.6% appreciation in the nominal effective exchange rate, providing no relief for commodity producers and a deterioration in the competitiveness of other exporters. Alberta, Saskatchewan, Northern BC and Newfoundland are suffering not only from weak commodity prices and regulatory strangulation, but also from a strong exchange rate generated by the BoC's unwillingness to cut the policy rate. Auto plants in Ontario are closing or laying off workers as Canada's competitiveness weakens.</span><br />
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<span style="font-size: large;">We are just now beginning to see the economic impact of Covid-19. Purchasing managers' surveys showed activity levels collapsed in both the manufacturing and services sectors in China. Declines are also likely to be recorded in Japan, Korea and other Asian countries in February. Measures now being taken in Europe and the United States suggest that as the virus spreads, so too will the economic weakness.</span><br />
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<span style="font-size: large;">Here in Canada, where hard economic data is published with a lag of up to six weeks relative to the United States, it would be foolish to wait for statistical evidence for the BoC to take action and cut the policy rate. Even without Covid-19, the failure to cut policy rates along with other major central banks has slowed growth and done so at the expense of the weakest sectors and regions of the country. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-72283600128536516742019-12-29T20:00:00.001-08:002019-12-29T20:00:57.638-08:00Biggest Macro Misses of 2019<span style="font-size: large;">I wasn't going to do this. I figured that after doing five years of "Biggest Macro Misses" that I had probably made my point. Economic and financial market forecasts that are rolled out at year end tend to be a poor guide for investment decisions for the year ahead. However, 2019 has seen both some of the biggest macro misses in years, but at the same time some remarkably good predictions of global equity market performance. </span><br />
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<span style="font-size: large;">So, as another year comes to a close, here I go again. For probably the last time, I will review how the macro consensus forecasts for 2019 that were made a year ago fared. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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 forecasts and compare them with what we now know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move -- sometimes dramatically -- when different economic outcomes transpire. When we look back, with the benefit of hindsight, we can see what the macro surprises were and interpret the market movements the surprises generated. 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 judge what were the macro drivers of 2019 investment returns and to assess whether they are sustainable.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Real GDP</span></h3>
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<span style="font-size: large;">A year ago, forecasters were overly optimistic about 2019 real GDP growth in the major economies. Weighted average real GDP growth for the twelve countries we monitor is now expected to be 3.0%, falling well short of the consensus forecast of 3.6% made a year ago. In the twelve economies, real GDP growth fell short of forecasters' expectations in eleven and met expectations in just one. The weighted mean absolute forecast error for the twelve countries was 0.6 percentage points, the biggest miss since 2015.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwLoeGenWB4I-X0CCxzi5KsHVUVxZ59KbqrRMThGknzZk60Fc65JqEHDZC1Jq9KzqBPIJVq5q8cXPe2ubrTgUNoSMUKSXMFQvo8CvPuMVr_DHm25Uuz1cArjCaArC-UshAQl-BXjea69Y/s1600/Real+GDP+Misses+2019.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="621" data-original-width="1233" height="322" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwLoeGenWB4I-X0CCxzi5KsHVUVxZ59KbqrRMThGknzZk60Fc65JqEHDZC1Jq9KzqBPIJVq5q8cXPe2ubrTgUNoSMUKSXMFQvo8CvPuMVr_DHm25Uuz1cArjCaArC-UshAQl-BXjea69Y/s640/Real+GDP+Misses+2019.png" width="640" /></span></a></div>
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<span style="font-size: large;">Based on current estimates, 2019 real GDP growth for Developed Market (DM) economies was 1.8% or 0.4% below last December's forecast, while growth for the Emerging Market (EM) economies that we follow was 4.6% or 0.7% below the forecast. Mexico, India, Australia and Korea had the biggest downside misses. </span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">CPI Inflation</span></h3>
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<span style="font-size: large;">Just as for global growth, the consensus forecast for global inflation for 2019 was off the mark, overestimating inflation in most countries. Nine of the twelve economies are on track for lower inflation than forecast, while inflation was higher than expected in just two countries. The weighted mean absolute forecast error for 2018 for the 12 countries was 1.0 percentage points, again the biggest forecast misses since 2015.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5HFcsXM5EMk4shuGmwaGm1rlyU01f47E0dL6R-MpM6LwnFSn6hgr7Eb1LmRKMZsUNBDTURbT73lwbioQKAg0InDujlD1CIT5asr7CxPrglqjkq0H30JLD1iOjpwMCe0Y9NndaoesAFxc/s1600/2019+CPI+Inflation+Misses.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="593" data-original-width="1227" height="308" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5HFcsXM5EMk4shuGmwaGm1rlyU01f47E0dL6R-MpM6LwnFSn6hgr7Eb1LmRKMZsUNBDTURbT73lwbioQKAg0InDujlD1CIT5asr7CxPrglqjkq0H30JLD1iOjpwMCe0Y9NndaoesAFxc/s640/2019+CPI+Inflation+Misses.png" width="640" /></span></a></div>
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<span style="font-size: large;">The biggest downside misses on inflation were for Mexico (-1.6 pct pts), Korea (-1.5), the Eurozone (-1.0) and Brazil (-0.9). The biggest upside misses were for India (+2.8 pct pts) and China (+1.9), where food prices rose much more than expected.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Central Bank Policy Rates</span></h3>
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<span style="font-size: large;">In 2019, economists' forecasts of central bank policy rates missed badly. Ten of the twelve central banks either unexpectedly cut their policy rate or failed to hike their policy rate by as much as forecast. Two central banks met expectations by standing pat.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7zM-i44KQi0DPOEdM7H1x6E8Czs1pewGRVEUJSWvzew0iM5rcqvg7uMLldQoyh6hu5T2TXztP0Tp3_z2CkPRnBi6GGC_5QXwmVyDkTOfuO_eexyCzaIThlYR3yw8y6WlA6bxIuqXsi6A/s1600/2019+Policy+Rate+Misses.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="604" data-original-width="1276" height="302" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7zM-i44KQi0DPOEdM7H1x6E8Czs1pewGRVEUJSWvzew0iM5rcqvg7uMLldQoyh6hu5T2TXztP0Tp3_z2CkPRnBi6GGC_5QXwmVyDkTOfuO_eexyCzaIThlYR3yw8y6WlA6bxIuqXsi6A/s640/2019+Policy+Rate+Misses.png" width="640" /></span></a></div>
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<span style="font-size: large;">In the DM, the Fed was expected to hike the policy rate by 75 to 100 basis points but instead did a U-turn and cut rates by 75bps. Most other central banks followed the Fed's lead, eschewing rate hikes and cutting rates instead. Japan's BoJ and China's PBoC met expectations by leaving their policy rates unchanged. The Bank of Canada and the Bank of England held rates steady rather than delivering expected rate hikes. Policy rates fell much more than expected in most EM economies, even in India and China where inflation surprised to the upside. </span><br />
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<span style="color: #b45f06; font-size: large;">10-year Bond Yields</span></h3>
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<span style="font-size: large;">Unfortunately, I was unable to collect meaningful 10-year bond yield forecasts for EM economies last year, so I will just compare DM forecasts with actual outcomes for 10-year yields. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiM1U6HPsmFKmmKR4Se6DHOnrzAHCzoQbnO8H0Kzv7QrzyxfZehM0h6YqcZRgpNOWl5uNZpJu_H09Gqsy5zzApwoNm6b2X2_FF13N3XBBC5r3hz3K06KxLwTRUbVMRzV5EALIP2xFOYirs/s1600/2019+10-yr+Bond+Yield+Misses.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="592" data-original-width="1229" height="308" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiM1U6HPsmFKmmKR4Se6DHOnrzAHCzoQbnO8H0Kzv7QrzyxfZehM0h6YqcZRgpNOWl5uNZpJu_H09Gqsy5zzApwoNm6b2X2_FF13N3XBBC5r3hz3K06KxLwTRUbVMRzV5EALIP2xFOYirs/s640/2019+10-yr+Bond+Yield+Misses.png" width="640" /></span></a></div>
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<span style="font-size: large;">For a second consecutive year, in all six DM economies that we track, 10-year bond yields surprised strategists to the downside. The US 10-year Treasury yield as expected to rise 55bps in 2019 as the Fed was expected to continue to tighten. Instead, US growth and inflation were weaker than expected, The Fed eased and the 10-year Treasury yield fell over 90bps. The weighted average DM forecast error was -1.22 percentage points, the biggest downside average miss since I began doing this in 2014. The biggest country miss was in Australia (-1.87 pct pts). The Aussie bond yield error was bigger than the year-end bond yield (1.60%). In the EM, bond yields also fell as global growth and inflation disappointed. </span><br />
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<span style="color: #b45f06; font-size: large;">Exchange Rates</span></h3>
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<span style="font-size: large;">With the Fed doing a policy U-turn in early 2019, most exchange rate forecasts were upset. How currencies fared depended in large part on the degree to which other central banks matched the Fed's policy shift. All of the major currencies were weaker than expected against the US dollar. The weighted mean absolute forecast error for the 11 currencies versus the USD was 3.5%.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOWknF_zZxpVt5t4VZCzb_oAu0V1AkZnLczVNFHZNO3ubxzeEvEIfyAtZ__mkq8gF64L4ivE48nRFeXuy1MTVD_qBaxR99b10NEykHSBsB1AxRzUc3FuqQU3r_Rn9fmfBGo3Qh8TL9cHM/s1600/2019+FX+Misses.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="595" data-original-width="1235" height="308" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOWknF_zZxpVt5t4VZCzb_oAu0V1AkZnLczVNFHZNO3ubxzeEvEIfyAtZ__mkq8gF64L4ivE48nRFeXuy1MTVD_qBaxR99b10NEykHSBsB1AxRzUc3FuqQU3r_Rn9fmfBGo3Qh8TL9cHM/s640/2019+FX+Misses.png" width="640" /></span></a></div>
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<span style="font-size: large;">A year ago, most forecasters thought that after the USD had outperformed all expectations in 2018, other major currencies would rebound somewhat. Weaker than expected growth and inflation kept the ECB in ultra-accommodative mode and the Euro weakened rather than strengthened. Australia was another case where growth and inflation badly undershot expectations and the RBA responded by unexpectedly easing by as much as the Fed, sinking the Aussie dollar. In contrast, the Bank of Canada kept it's policy rate steady despite weaker than expected growth and the result was a stronger than expected Canadian dollar. </span><br />
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<span style="font-size: large;">The biggest FX forecast misses for the DM economies were for the Euro (which was 7.4% weaker than expected) and the Australian Dollar (-6.9%). Among EM currencies, China and India saw depreciations that were in line with expectations, while Mexico and Russia experienced appreciations that were larger than expected as oil prices firmed. </span><br />
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<span style="color: #b45f06; font-size: large;">Equity Markets</span></h3>
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<span style="font-size: large;">News outlets gather equity market forecasts from high profile US strategists and Canadian bank-owned dealers. A year ago, after a sharp global equity market correction in 4Q18, equity strategists were optimistic that North American stock markets would post a strong rebound in 2019. As shown below, those forecasts called for 2019 gains of 21% for the S&P500 and 13% for the S&PTSX Composite. They were right, but for the wrong reason. Global growth and inflation surprised forecasters to the downside, causing the Fed and other central banks to do a policy U-turn. Both bond and equity markets surged on the unexpected central bank reversal. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSw7zMkVNI-WEcANUslFQPB9cD3xtWTstl0jvBBSL4fELBSIioPiQ2Pwt3TS7snN3f0z6WJ0GNwaXYICNLWQWN13BpkEn4wrznAC8XoWG-3wZICHtZUbi1ikchV5m4jiwOxxkabk16BZQ/s1600/2019+Equity+Misses.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="592" data-original-width="1150" height="328" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSw7zMkVNI-WEcANUslFQPB9cD3xtWTstl0jvBBSL4fELBSIioPiQ2Pwt3TS7snN3f0z6WJ0GNwaXYICNLWQWN13BpkEn4wrznAC8XoWG-3wZICHtZUbi1ikchV5m4jiwOxxkabk16BZQ/s640/2019+Equity+Misses.png" width="640" /></span></a></div>
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<span style="font-size: large;">As of December 29, 2018, the S&P500, was up 30.3% year-to-date (not including dividends) for an error of +8.9 percentage points. The S&PTSX300 was up 20.7% for an error of +7.7 percentage points.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkOmRni2O_5Gnq95sDONa3tbz3N2xIHTMappIEr1NEdUgLDg9A1zjW-C0cS4ZIn8b3kio5MWDmr_Mn_BQZ9udX1yfjXXdPxKZ-lIeGBE9qMX2u4WCmyrdqElyCAsoXA2TQe4JIaPRhyphenhyphenqA/s1600/2019+Actual+Equity+Performance.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="661" data-original-width="1206" height="350" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkOmRni2O_5Gnq95sDONa3tbz3N2xIHTMappIEr1NEdUgLDg9A1zjW-C0cS4ZIn8b3kio5MWDmr_Mn_BQZ9udX1yfjXXdPxKZ-lIeGBE9qMX2u4WCmyrdqElyCAsoXA2TQe4JIaPRhyphenhyphenqA/s640/2019+Actual+Equity+Performance.png" width="640" /></span></a></div>
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<span style="font-size: large;">Globally, </span><span style="font-size: large;">after horrible performance in 2018, </span><span style="font-size: large;">stock markets rallied back along with US equities. US equities generally had more modest losses in 2018, followed by bigger gains in 2019 than other global equity markets. </span><br />
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<span style="color: #b45f06; font-size: large;">Investment Implications</span></h3>
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<span style="font-size: large;">In 2019, global macro forecast misses were the biggest since 2014-15. Global growth and inflation were both weaker than expected, but an unexpected policy U-turn by global central banks resulted in unexpectedly strong returns for bonds and an even bigger than expected rebound in global equities from the late-2018 correction. </span><br />
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<span style="font-size: large;">For Canadian investors, the appreciation of CAD against the USD meant that returns (in CAD terms) on foreign equities and government bonds were reduced if the USD currency exposure was left unhedged. US equities still outperformed Canadian equities in CAD terms, but Canadian equities outperformed most other global equity markets if foreign currency exposure was left unhedged. Meanwhile, Canadian bonds outperformed US Treasuries and other foreign government bonds in CAD terms despite the lack of policy easing by the BoC.</span><br />
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<span style="font-size: large;">As 2020 economic and financial market forecasts are rolled out, it is worth reflecting that, for a variety of reasons, such forecasts have been a poor guide to investment decisions for several years running. While forecasters' are once again optimistic in light of the partial trade truce between the US and China, the lesson of 2019 is that forecasters have very limited ability to provide actionable investment guidance. 2020 will undoubtedly once again see some large consensus forecast misses as new surprises arise. </span><br />
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<br />TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com2tag:blogger.com,1999:blog-3338983638234895144.post-28080266657001821872019-01-01T21:26:00.000-08:002019-01-01T21:26:30.903-08:00Global ETF Portfolios: 2018 Returns for Canadian Investors<span style="font-size: large;">In 2018, aggregate global growth and inflation matched forecasters expectations, but portfolio returns fell far short of what was expected a year ago. At that time, the consensus forecast for global growth was the most optimistic in years and central banks were expected to continue on the path of unwinding monetary stimulus. The expectation among global strategists was for positive single-digit equity returns and weak bond market returns, consistent with consensus views that strong, synchronized global growth, Trump's tax cuts, and central bank withdrawal of stimulus would support equity returns while depressing bond returns. That is not what happened!</span><br />
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<span style="font-size: large;">The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavor, we track various portfolios made up of different combinations of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios. </span><br />
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<span style="font-size: large;">Since we began monitoring our Global ETF portfolios at the end of 2011, we have found that the global portfolios we monitor have all vastly outperformed a simple all-Canada 60/40 portfolio. this proved true once again in 2018.</span><br />
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<span style="font-size: large;">A stay-at-home Canadian investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 2018 total return (including reinvested dividend and interest payments) of -5.2% in Canadian dollars. This virtually wiped out the all-Canada portfolio gain of 2017. All of our global ETF portfolios outperformed the all-Canadian portfolio in 2018. </span><br />
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<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 2018</span></h3>
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<span style="font-size: large;">In 2018, with the CAD depreciating almost 8% against USD, over 4% against the JPY and relatively unchanged against the Euro, the best global ETF returns for Canadian investors were in US government bonds and gold. The worst returns were in Eurozone, Emerging Market and Canadian equities. The chart below shows 2018 returns, including reinvested dividends, for the ETFs tracked in this blog. The returns are shown in USD terms (green bars) and in CAD terms (blue bars).</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTuA2Xw1Yc8KzGBHLQPtWOb7oI957AM9fvObfcmZnCR1-Bge-GLg7btSI9lIV0lRJozb1znj9nsQ6-30U876GqWprmwJQKV9qo5WV7qoSOWlrvdu66N8k5_gtFZ66eu_zVzW9S6nQzoTA/s1600/2018+Global+ETF+Returns.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="449" data-original-width="734" height="390" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTuA2Xw1Yc8KzGBHLQPtWOb7oI957AM9fvObfcmZnCR1-Bge-GLg7btSI9lIV0lRJozb1znj9nsQ6-30U876GqWprmwJQKV9qo5WV7qoSOWlrvdu66N8k5_gtFZ66eu_zVzW9S6nQzoTA/s640/2018+Global+ETF+Returns.jpg" width="640" /></span></a></div>
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<span style="font-size: large;">Only one of the 19 Global ETFs that we track posted a positive USD total return in 2018. That was TLH, the Long-term (10-20yr) US Treasury Bond ETF, which returned +0.4% if monthly distributions were reinvested.</span><br />
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<span style="font-size: large;">In CAD terms, returns on unhedged foreign currency ETFs were boosted by the depreciation of the Canadian dollar. The best gains were in the Long-term US Treasury Bond (TLH) which returned 8.8% in CAD terms and the US Treasury Inflation Protected Bonds (TIP) which returned 7.1%. Other gainers in CAD terms were the Non-US Government Bonds (BWX), the Gold (GLD), the US High Yield Corporate Bond (HYG), the US Investment Grade Corporate Bond (LQD). The only equity ETF to make a positive return in CAD terms was the S&P500 (SPY) which returned 3.5%. Small positive returns were also made in the USD Emerging Market Bond (EMB), the World Inflation Protected Bond (WIP), the Canadian Corporate Bond (XCB) and the Canadian Long Bond (XLB). </span><br />
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<span style="font-size: large;">The worst performers in CAD terms were the Eurozone Equity ETF (FEZ) which returned -8.7%, the Emerging Market Equity (EEM) -8.1%, and the Canadian Equity (XIU) -7.8%. Other losers were the Japanese Equity (EWJ), the Commodity ETF (GSG), and the US Small Cap Equity (IWM).</span><br />
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<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance</span></h3>
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<span style="font-size: large;">In 2018, the global ETF portfolios tracked in this blog posted mixed returns in CAD terms when USD currency exposure was left unhedged, but negative returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFyBI1u0nB-An5BbQgGSLdIejKRUdnE3F8_A7WDZ9dgtjSyNDEX_DVNv-XnglE8VXPljFRhuzIxL-SP1-iouakpaTRlNHvq7zFWbIQrjxHkP5tbu_S_3xjb9MEsYdG0KM5nXCt5mYF6LI/s1600/2018+Global+ETF+POrtfolio+Returns.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="355" data-original-width="610" height="372" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFyBI1u0nB-An5BbQgGSLdIejKRUdnE3F8_A7WDZ9dgtjSyNDEX_DVNv-XnglE8VXPljFRhuzIxL-SP1-iouakpaTRlNHvq7zFWbIQrjxHkP5tbu_S_3xjb9MEsYdG0KM5nXCt5mYF6LI/s640/2018+Global+ETF+POrtfolio+Returns.jpg" width="640" /></span></a></div>
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<span style="font-size: large;">A simple Canada only 60% equity/40% Bond Portfolio returned -5.2%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned -1.5% in CAD terms when USD exposure was left unhedged, and -5.6% 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 0.5% if unhedged, but had a negative return of -3.8% if USD hedged.</span><br />
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<span style="font-size: large;">Risk balanced portfolios outperformed in 2018 if left unhedged, but performed poorly if USD exposure was hedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 2.1% in CAD terms if USD-unhedged, but lost 5.6% 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, returned 1.8% if USD-unhedged, but lost 4.4% if USD-hedged.</span><br />
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<span style="color: #b45f06; font-size: large;">Four Key Events of 2018</span></h3>
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<span style="font-size: large;">In my view, there were four key economic and policy developments that left a mark on portfolio returns in 2018. The first was the interaction of the fiscal stimulus provided by President Trump's tax cuts and Federal Reserve's determination to normalize US monetary policy. The second was Trump's aggressive approach to trade policy, first in NAFTA negotiations and then in tariffs targeting China. The third was the increasing divergence between stronger than expected US growth and weaker than expected growth outside the US. The fourth was the Government of Canada's mismanagement of regulatory policies governing the building of pipelines to provide access for Canadian oil to world markets. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgheaGSzxeisATfh2G2BrLJbPKXLXyUPydQfF1WcRYkvM3mzO4SVmGHf7AjBGLs0zzVUKfUOAWPGZbimisp8WkptSfnJYNc4NuViqJhWgpIGe9aA8zxeM8Oh0Kx2P1cxJBjcYmBTToEj2k/s1600/2018+Weekly+ETF+Portfolio+Performance.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="789" data-original-width="1075" height="468" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgheaGSzxeisATfh2G2BrLJbPKXLXyUPydQfF1WcRYkvM3mzO4SVmGHf7AjBGLs0zzVUKfUOAWPGZbimisp8WkptSfnJYNc4NuViqJhWgpIGe9aA8zxeM8Oh0Kx2P1cxJBjcYmBTToEj2k/s640/2018+Weekly+ETF+Portfolio+Performance.png" width="640" /></span></a></div>
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<span style="font-size: large;">After a promising January, both bond and equity markets stumbled badly in February as an uptick in US wage growth prompted markets to price in more aggressive tightening by the Fed. At the same time, Trump threatened to pull out of NAFTA unless Canada and Mexico got serious about accepting US negotiating demands. As the wage uptick proved temporary and NAFTA negotiations resumed, Trump implemented steel and aluminum tariffs and began the process of ratcheting up tariffs on China. In the summer, Trump threatened to impose 25% tariffs on vehicles produced in Canada and Mexico, if they wouldn't agree with his NAFTA demands. Through this period, Emerging Market equities and currencies fell sharply. As global growth stumbled in 3Q, with both the Eurozone and Japan posting real GDP declines, weakness in equity markets spread to Europe, Japan and Canada. Slowing global growth, including in China, weakened commodity prices. Crude oil prices fell on slowing global demand and booming US supply. Canadian oil prices tanked, as the rising Canadian oilsands production was shut in by inadequate pipeline capacity. As risk markets sold off, volatility rose, and inflation plateaued, both the Fed and the Bank of Canada continued to signal steady withdrawal of monetary stimulus. Meanwhile, as the Republicans lost control of the House of Representatives, Trump continued to ratchet up tariff pressure on China, hoping to force a deal. </span><br />
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<span style="font-size: large;">The impact on portfolio returns is clearly shown in the above chart. All portfolios stumbled in February-March, but recovered through the spring into mid-summer. Both US and Canadian equity equity markets managed to put in record highs as bond yields rose. The combination of slowing global growth, rising US-China trade frictions and central banks apparent unconcern about market volatility, proved a trifecta that led to the the sharp 4Q equity market correction and a muted bond market rally. When the Fed tightened for the fourth time of the year in December and Chairman Powell suggested that Fed balance sheet reduction was on auto pilot, it only added to the huge selloff in US and global equities in December. Only then did Fed officials begin to signal some flexibility on the monetary policy. But by this time, the damage to risk markets was done. </span><br />
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<span style="font-size: large;">From their August highs in the +5 to 6% range, year-to-date returns for Canadian investors in Global ETF portfolios shrank to the -2 to +2% range in the final four months of the year. The All Canada Portfolio return sank from +3% in mid-July to -5% by yearend.</span><br />
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<span style="color: #b45f06; font-size: large;">Looking Ahead </span></h3>
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<span style="font-size: large;">As we enter 2019, two crucial questions face markets. The first is whether "The Great Unwind" of unconventional monetary policy that began in mid-2017 will proceed as signaled by the FOMC or whether faltering momentum in the global economy will force central banks to pause indefinitely or even reverse course. The second is whether the US-China trade dispute will lead to a face-saving ceasefire or to an all-out trade war. The two issues are inter-related. Withdrawal of stimulus by the Fed spills over into tighter global financial conditions, pressuring China's highly leveraged economy. Trade tensions and tariff hikes weaken global growth and add to coast pressures, a toxic mix for equity markets. </span><br />
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<span style="font-size: large;">While the consensus outlook expects slowing but still solid global growth in 2019, markets do not currently share most economists view of a "soft landing" and central banks withdraw stimulus. The best hopes for stronger portfolio performance for Canadian investors in 2019 would be a US-China trade truce, a Fed that pauses and reasserts "data dependence" as key for additional monetary policy normalization, and a U-turn in Canadian government policy toward resource development and transportation. If these hopes materialize, 2019 could be a very good year for investors. If not, the last four months of 2018 will likely prove to be just the beginning of a sustained bear market in risk assets.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-67011161564330406212018-12-22T10:56:00.000-08:002018-12-22T10:56:09.892-08:00Biggest Global Macro Misses of 2018<span style="font-size: large;">As another year comes to a close, it is time to review how the macro consensus forecasts for 2018 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 forecasts and compare them with what we now know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move -- sometimes dramatically -- when a different outcomes transpire. When we look back, with 20/20 hindsight, we can see what the macro surprises were and interpret the market movements the surprises generated. 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 the macro drivers of 2018 investment returns and to assess whether they are sustainable.</span><br />
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<span style="color: #b45f06; font-size: large;">Real GDP</span></h3>
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<span style="font-size: large;">In 2018, forecasters accurately forecast global real GDP growth. Weighted average real GDP growth for the twelve countries we monitor is now expected to be 3.7%, exactly matching the consensus forecast of 3.7% made a year ago. While the global growth forecast was bang on, the individual country GDP forecasts were not. In the twelve economies, real GDP growth exceeded forecasters' expectations in just three and fell short of expectations in nine. The weighted mean absolute forecast error for the twelve countries was 0.4 percentage points, about the same as the 2017 error.</span><br />
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<span style="font-size: large;">Based on current estimates, 2018 real GDP growth for the US exceeded the December 2017 consensus forecast by 0.5 percentage points (pct pts). Growth also slightly exceeded consensus expectations in Australia and China. The biggest downside misses on growth for 2018 were for Brazil (-1.5 pct pts), Japan (-0.7), Russia (-0.6), the Eurozone (-0.3), and India (-0.3). On balance, a big upside miss on US growth was offset by downside misses in other economies.</span><br />
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<span style="color: #b45f06; font-size: large;">CPI Inflation</span></h3>
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<span style="font-size: large;">Just as for global growth, the consensus forecast for global inflation for 2018 was very accurate. Average inflation for the twelve countries is now expected to be 2.4% compared with a consensus forecast of 2.4%. And just as for growth, upside misses just offset downside misses. Six of the twelve economies are on track for higher inflation than forecast, while inflation was lower than expected in six countries. The weighted mean absolute forecast error for 2018 for the 12 countries was 0.4 percentage points, down from a 0.6% average miss last year.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRGCsicGv5S5P3io6o2wbi2UFWS9xoriIa3pSZd7e7LVDLeX2OKkJp1v9TFHITsXA8MOyGMYw0mv7rjJgobvq3DM3ZVIXFEDwLGKCQP_ekZ_Rk4ftynIaAWdoSUQTHrnIfm1wH3Se0FSs/s1600/CPI+Misses+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="597" data-original-width="1289" height="296" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRGCsicGv5S5P3io6o2wbi2UFWS9xoriIa3pSZd7e7LVDLeX2OKkJp1v9TFHITsXA8MOyGMYw0mv7rjJgobvq3DM3ZVIXFEDwLGKCQP_ekZ_Rk4ftynIaAWdoSUQTHrnIfm1wH3Se0FSs/s640/CPI+Misses+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">The biggest downside misses on inflation were in India (-1.9 pct pts), and the UK (-0.3). The biggest upside miss on inflation were in Mexico (+1.1 pct pts) and the Eurozone (+0.6%).</span><br />
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<span style="color: #b45f06; font-size: large;">Central Bank Policy Rates</span></h3>
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<span style="font-size: large;">In 2018, economists' forecasts of central bank policy rates were, on balance, slightly too high. Four central banks hiked their policy rate by more than expected while six central banks hiked less than expected.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgGZjGTdDevkz6tNDxx-nEOolfMtEo5tHrh5ouMnWrZF4fyY-kY9f130BaGZZNVigehyYKUetyPsal2vvaYgQLd54kf5chO3slebUeICuuTKFSH55gpSvhzvA63rYsylesoBLKNDW1kV7E/s1600/Policy+Rate+Misses+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="604" data-original-width="1276" height="302" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgGZjGTdDevkz6tNDxx-nEOolfMtEo5tHrh5ouMnWrZF4fyY-kY9f130BaGZZNVigehyYKUetyPsal2vvaYgQLd54kf5chO3slebUeICuuTKFSH55gpSvhzvA63rYsylesoBLKNDW1kV7E/s640/Policy+Rate+Misses+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">In the DM, the Fed hiked the Fed Funds rate four times, one more than the consensus expected. The ECB and the BoJ met expectations by leaving their policy rates unchanged. The Bank of Canada and the Bank of England hiked slightly less than the consensus expectation. The Reserve Bank of Australia remained on hold instead of hiking once as the consensus expected. In the EM, as usual, the picture was more mixed. Brazil's central bank was able to cut its policy rate more than expected. Russia was expected to cut its policy rate but was unable to do so. In China, the PBoC stayed on hold, as expected, but did cut reserve requirements as the economy struggled to meet the government's growth target. India's RBI was expected to remain on hold in 2018, but had to raise its' policy rate. Mexico extended the trend of late 2016-17, tightening more than expected as inflation rose in response to the weakening of the Mexican Peso. </span><br />
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<span style="color: #b45f06; font-size: large;">10-year Bond Yields</span></h3>
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<span style="font-size: large;">In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCkvB864IykEaVUzrklta5s9vJKWFTYrLpcS8sjXI0Xf5rCKbiXyXvbIrCDBHiy6U8Yo3-YK72u3ZRSZT4WoQsgJfkVrCGwVGdN0EP04-Q_q_CkBJTpR4JyQc4BNGr_sGBtOpNhbXACxg/s1600/Bond+Yield+Misses+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="612" data-original-width="1286" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCkvB864IykEaVUzrklta5s9vJKWFTYrLpcS8sjXI0Xf5rCKbiXyXvbIrCDBHiy6U8Yo3-YK72u3ZRSZT4WoQsgJfkVrCGwVGdN0EP04-Q_q_CkBJTpR4JyQc4BNGr_sGBtOpNhbXACxg/s640/Bond+Yield+Misses+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">In all six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.30 percentage points, the same as for 2017. The biggest misses were in Australia (-0.74 pct pts), Canada (-0.57), the Eurozone (proxied by Germany, -0.55), the UK (-0.35 pct. pt.). In the EM, the picture was mixed as bond yields were lower than forecast in Brazil (-1.78 pct pts) and Korea (-0.75). However, bond yields rose more than expected in Russia (+1.91), Mexico (+1.20) and India (0.36).</span><br />
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<span style="color: #b45f06; font-size: large;">Exchange Rates</span></h3>
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<span style="font-size: large;">All of the major currencies were weaker than expected against the US dollar. The weighted mean absolute forecast error for the 11 currencies versus the USD was 7.5%.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOBCucSzllRPNeJ9zgIFQGV8yocWSjQQwaRePSxDKGaN5hYb9Hs8jzDaWTG5cQp1o-9sWeFXKOVSTPuRDu_3X2R0Z_9K6UuVg1mrAZocv6MGf9LSz20ce9QAESnXmKAsYooioLgtas178/s1600/FX+Misses+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="597" data-original-width="1284" height="296" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOBCucSzllRPNeJ9zgIFQGV8yocWSjQQwaRePSxDKGaN5hYb9Hs8jzDaWTG5cQp1o-9sWeFXKOVSTPuRDu_3X2R0Z_9K6UuVg1mrAZocv6MGf9LSz20ce9QAESnXmKAsYooioLgtas178/s640/FX+Misses+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">The USD was expected to strengthen following the election of Donald Trump as President. In 2017, however, USD unexpectedly weakened reflecting early delays in implementation of Trump's promised tax cuts, hesitation to tighten by the Fed, unexpected tightening by some other central banks and ebbing political uncertainties in emerging economies. In 2018, as Trump's tax cuts took effect, the Fed hiked four times and shrank its' balance sheet, and Trump began his strategy of raising tariffs to pressure trading partners into more advantageous trade arrangements, the USD outperformed all expectations.</span><br />
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<span style="font-size: large;">The biggest FX forecast misses for the DM economies were for the Canadian Dollar (which was 11.4% weaker than expected), the UK Pound (-9.3%), the Australian Dollar (-8.5%) and the Euro (-8.0%). EM currencies also weakened sharply against USD, led by the Russian Ruble (-17.2%), Brazilian Real (-15.5%) and Indian Rupee (-6.7%). </span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Equity Markets</span></h3>
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<span style="font-size: large;">News outlets gather equity market forecasts from high profile US strategists and Canadian bank-owned dealers. A year ago, equity strategists were optimistic that North American stock markets would turn in a modest, if unspectacular, positive performance in 2018. This call was far off the mark. As shown below, those forecasts called for 2018 gains of 5.7% for the S&P500 and 4.9% for the S&PTSX Composite.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiAhC9PoiTLbT08Adf4yA90aOkQGMIr3fWtK9CWI070yNwDGMDfCNaWYIQubCnAc_bVcKHL8kl9KNGIDIo9AQr3OftR_pC2RZT6wckgVe-TYdpiHIH_q0jqW5DkK23jV4fY7okxyYgX6kc/s1600/Stock+Market+Misses+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="592" data-original-width="1150" height="328" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiAhC9PoiTLbT08Adf4yA90aOkQGMIr3fWtK9CWI070yNwDGMDfCNaWYIQubCnAc_bVcKHL8kl9KNGIDIo9AQr3OftR_pC2RZT6wckgVe-TYdpiHIH_q0jqW5DkK23jV4fY7okxyYgX6kc/s640/Stock+Market+Misses+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">As of December 21, 2018, the S&P500, was down 9.2% year-to-date (not including dividends) for an error of -14.9 percentage points. The S&PTSX300 was down 14.0% for an error of -18.9 percentage points.</span><br />
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<span style="font-size: large;">Although global real GDP growth, global inflation and major central bank actions were close to consensus forecasts, the divergences from consensus expectations across countries proved a toxic mix for equities. Stronger than expected US growth and a slight uptick of inflation were met with a slightly quicker normalization of the US policy rate and a steady reduction in the size of the Fed's balance sheet. As the Fed persisted with plans to continue tightening amid slowing growth in Europe, Japan and Emerging Markets, equity markets fell like dominoes. Declines began in EM, spread to Europe and Japan, and finally reached US equity markets in the final two months of 2018. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsX4EF8CjuSYOKWll6aGL1wv6bz_osFhoM0mx95lh27Xz4Pebyzq1fGJDkmlrUHgwVgq3tmWoDvc48CyDrEKNpvJfruoCLEXhPQljTFxa0P95UxFfjOtzWyPAYVvKMFqbiUIJ-ulp5U0Q/s1600/Actual+Stock+Markets+2018.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="612" data-original-width="1287" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsX4EF8CjuSYOKWll6aGL1wv6bz_osFhoM0mx95lh27Xz4Pebyzq1fGJDkmlrUHgwVgq3tmWoDvc48CyDrEKNpvJfruoCLEXhPQljTFxa0P95UxFfjOtzWyPAYVvKMFqbiUIJ-ulp5U0Q/s640/Actual+Stock+Markets+2018.png" width="640" /></span></a></div>
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<span style="font-size: large;">Globally, stock market performance (in local currency terms) was horrible. The Eurozone and Canada led declines in DM equity markets. China, Korea and Mexico led decliners in EM markets. Brazil and India, bucking the global trend, posted gains. </span><br />
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<span style="color: #b45f06; font-size: large;">Investment Implications</span></h3>
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<span style="font-size: large;">In 2018 global macro forecast misses were once again quite different from those of recent years. The accuracy of global growth and inflation forecasts masked unexpected divergences in growth and inflation from expectations for individual countries. Stronger than expected US growth, faster than expected Fed tightening and Trump's tariff increases saw the USD strengthen against all of the major currencies. This mix was particularly difficult for EM economies, including China, with large amounts of USD-denominated debt. As EM economies slowed, crude oil and other commodity prices fell sharply, dimming prospects for countries like Canada and Australia. </span><br />
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<span style="font-size: large;">Stronger than expected growth had US stocks outperforming bonds for most of the year. Market concerns that the Fed would continue tightening even as growth outside the US was faltering contributed to the sharp fall in global equity prices in 4Q18. By year end, both US equity and bond prices had fallen, but bonds outperformed as risk aversion took hold.</span><br />
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<span style="font-size: large;">For Canadian investors, the depreciation of CAD against the USD meant that returns (in CAD terms) on government bonds denominated in US dollars were boosted if the USD currency exposure was left unhedged. The only slight positive returns for Canadian investors came in Canadian and unhedged foreign bonds. </span><span style="font-size: large;">The outperformance of globally diversified portfolios over stay-at-home Canadian portfolios continued in 2018. </span><br />
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<span style="font-size: large;">As 2019 economic and financial market forecasts are rolled out, it is worth reflecting that, for a variety of reasons, such forecasts have been a poor guide to investment decisions for several years running. While forecasters' optimism about global growth remains in place, cracks are now forming. 2019 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. </span><br />
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<span style="font-size: large;">Last year in this space, I said: </span><br />
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<span style="font-size: large;">The 2017 macro surprises, higher than expected growth and lower than expected inflation, are now being built in to 2018 views. This actually increases the chances of disappointments that are negative for equities and other risk assets. </span></blockquote>
<span style="font-size: large;">Although it took until late in the year, those disappointments did arrive in 2018. This has left the global economy and financial markets in an uncertain and somewhat precarious position heading into 2019. With central banks focussed on "normalizing" monetary policy, the buoyant financial market performance that accompanied massive expansion of central bank balance sheets is increasingly looking like it's going into reverse.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-11664823306689034102018-07-18T19:52:00.002-07:002018-07-23T06:11:29.190-07:00For Canada, Full Capacity Is Not Full Potential<span style="color: #b45f06; font-size: large;"><i>The conventional view serves to protect us from the painful job of thinking.</i> </span><br />
<span style="color: #b45f06; font-size: large;"> John Kenneth Galbraith</span><br />
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<span style="font-size: large;">The Bank of Canada hiked it's policy rate by 25 basis points to 1.5% on July 11, in a move that was widely anticipated by the consensus.</span><br />
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<span style="font-size: large;">As the C.D. Howe Institute's Monetary Policy Council (of which I am a member) said on July 5,</span><br />
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<span style="font-size: large;">All but one of the nine MPC members who attended this meeting called for an overnight rate target higher than the current one at the upcoming meeting on Wednesday 11 July. The near unanimity reflected the group’s view that Canadian economic data in the second quarter have rebounded from a sluggish beginning to 2018. Output has risen since April, with the Business Outlook Survey suggesting we are at or above productive capacity. The labour market is also showing signs of tightening with growth in average hourly earnings at its highest level since 2008.</span></blockquote>
<span style="font-size: large;">This is the conventional wisdom which nearly everyone with an educated opinion accepts. It is based on the notion that the economy has reached or exceeded its' full capacity. The unemployment rate, which ticked up last month, had previously fallen to its lowest since comparable data became available in 1976. Wage growth, as measured by average hourly earnings of permanent employees reached 3.9% in May, the highest since 2008. </span><br />
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<span style="font-size: large;">One analyst, who I have high regard for, recently wrote,</span><br />
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<span style="font-size: large;">The Canadian economy is in an interesting position approaching the middle of 2018. Growth has slowed in recent quarters, after a very strong 2017H1. There are convincing signs, however, that this slowing reflects the economy hitting capacity constraints, rather than a sudden fall off in demand. Consistent with this, genuine inflation pressures have become more evident. Canada is the only G7 country to experience a significant acceleration in wage inflation as the unemployment rate has fallen below traditional estimates of NAIRU.All these factors suggest that the Bank of Canada is behind the curve on its policy of rate normalization.</span></blockquote>
<span style="font-size: large;">When I read such analysis or the financial press, the message that comes through is that: </span><br />
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<li><span style="font-size: large;">Because growth of demand (or GDP) has been stronger than potential, Canada's economy has reached or exceeded it's full productive capacity; and </span></li>
<li><span style="font-size: large;">Because the labour market has reached a 40+ year tightness, wage growth is accelerating and putting upward pressure on inflation; </span></li>
<li><span style="font-size: large;">The Bank of Canada should play catch up in "normalizing" it's policy rate.</span></li>
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<span style="font-size: large;">I believe that neither of the first two points is an accurate description of the current situation in Canada and therefore, that the conclusion about Bank of Canada policy does not follow.</span><br />
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<span style="color: #b45f06; font-size: large;">Why is Canada facing capacity pressures?</span></h3>
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<span style="font-size: large;">I don’t share the view that growth has slowed because of capacity constraints that have pushed up wages. I believe the latest acceleration in wages in a slowing economy was driven by sharp increases in minimum wages in several provinces, which began in 2017. </span><br />
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<span style="font-size: large;">Across Canada's ten provinces, the minimum wage rose by a weighted average 4.1% in 2017 (led by an 11.5% hike in Alberta) and by 11.0% in 2018 (led by a 20.7% hike in Ontario). Minimum wage hikes, not excess labour demand, have forced employers to raise wages not only for minimum wage employees, but also for employees who had moved to above-minimum-wage status, to maintain some equity and premium for experience. </span><span style="font-size: large;">With 15% of employees affected directly or indirectly, these minimum wage hikes are sufficient to explain the majority of the acceleration average hourly wages for the total workforce.</span><span style="font-size: large;"> </span><span style="font-size: large;">The sharp increase in early 2018 is probably also partly responsible for employment having declined 50,000 in the first five months of 2018.</span><br />
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<span style="font-size: large;">I would characterize </span><span style="font-size: large;">capacity utilization reaching cyclical highs even as </span><span style="font-size: large;">growth has slowed as being caused by insufficient business non-residential investment. The chart below compares Canada and US real nonresidential business investment to GDP.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi093cBezqCosdd0xWdnblkIZ9F_gekb1RqYeasi_zLVqhdHINwl1huwuXbh8ebBEwLNiBV1RReNkAH27w8Bj6nW-CJenZDI3JD6s69ibFPCMQF_rM01UvUp01fv8HJ4omT24Wl2RjslJA/s1600/BFI+Corrected.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="1121" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi093cBezqCosdd0xWdnblkIZ9F_gekb1RqYeasi_zLVqhdHINwl1huwuXbh8ebBEwLNiBV1RReNkAH27w8Bj6nW-CJenZDI3JD6s69ibFPCMQF_rM01UvUp01fv8HJ4omT24Wl2RjslJA/s640/BFI+Corrected.png" width="640" /></a></div>
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<span style="font-size: large;">Over the past two decades, Canada has lagged the United States in business investment in plant, equipment and intellectual property. Canada's real investment rose as a percentage of GDP in the periods leading into 2008 and into 2014 when global crude oil prices were strong, boosting investment in Canada's oil and gas industry, led by growth of oil-sands production. Since the collapse of crude oil prices in 2014, followed by aggressive new government regulations and taxes in pursuit of climate change objectives, Canadian business investment fell to recessionary levels in 2016-17. While US business investment as a percentage of GDP has risen to a 20-year high, Canada's investment has fallen toward two decade lows.</span><br />
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<span style="font-size: large;">The mix of Canada's business investment also demonstrates weakness. The charts below show Canada-U.S. comparisons of business spending on machinery and equipment, nonresidential structures and intellectual property.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTt7amIdvijjMYcTPTt_1f4rz2xw-NRQsGgwivXJtWNs0YNteWugP0o7rCG18elxXelRA07kYAIRqi983mIzTblke7wHYI-niEgyB2_xQWSmWLzlRpJitKwc1o29upc6jNF8GtRY4wZj8/s1600/M%2526E.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="1121" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTt7amIdvijjMYcTPTt_1f4rz2xw-NRQsGgwivXJtWNs0YNteWugP0o7rCG18elxXelRA07kYAIRqi983mIzTblke7wHYI-niEgyB2_xQWSmWLzlRpJitKwc1o29upc6jNF8GtRY4wZj8/s640/M%2526E.png" width="640" /></a></div>
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<span style="font-size: large;">US spending on machinery and equipment reached 6.5% of GDP in 1Q18, its' highest level in over 20 years. Meanwhile, Canada's spending on M&E was one-third lower at just 4.1% of GDP, still below the level reached prior to the Great Financial Crisis. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-6aCEObRRl1XvdJv4g87ycLqpf0MNWbWdmfW4nhVlKtpvSiqtdhGxQli8A0O2BIoiIl_s7OvwQc14dq_WWR9AfBUNxH5nEhIKW84Edg0SyyPCXUHAHqlCfgq8aUFiGBJe6r3PGz-5UTo/s1600/IP.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="1121" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-6aCEObRRl1XvdJv4g87ycLqpf0MNWbWdmfW4nhVlKtpvSiqtdhGxQli8A0O2BIoiIl_s7OvwQc14dq_WWR9AfBUNxH5nEhIKW84Edg0SyyPCXUHAHqlCfgq8aUFiGBJe6r3PGz-5UTo/s640/IP.png" width="640" /></a></div>
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<span style="font-size: large;">US business spending on intellectual property has been rising strongly and reached 4.5% of GDP in 1Q18. This was well over double Canada's spending of just 1.8% of GDP.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6cZadFrYxzlwks1ImA3kutjQDQYj12J5B69mVC94S1YYsScLAUSI2_Cgq6G8eQupFd6o-Lb_KNVVo6LeZoudF2D14EAa8kvcEhb2dOxr-7c5GAKcPVmXvNLjo3aJ3Sq0IaDiT3LLsH7c/s1600/NonRes+Structures.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="1122" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6cZadFrYxzlwks1ImA3kutjQDQYj12J5B69mVC94S1YYsScLAUSI2_Cgq6G8eQupFd6o-Lb_KNVVo6LeZoudF2D14EAa8kvcEhb2dOxr-7c5GAKcPVmXvNLjo3aJ3Sq0IaDiT3LLsH7c/s640/NonRes+Structures.png" width="640" /></a></div>
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<span style="font-size: large;"> </span><br />
<span style="font-size: large;">Canada's business spending on non-residential structures rose to 5.5% of GDP in 1Q18, well below the peak level of 7.5% reached in 2Q14. The decline in crude oil prices slowed energy investment after 2014 and increased regulation stalled investment in pipeline building. Canada still devotes almost double the US investment to nonresidential structures.</span><br />
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<span style="font-size: large;">Canada's mix of business investment, which has been heavily skewed toward energy investment is a disadvantage when crude oil prices are weak and when governments prioritize environmental concerns. Canada has badly lagged the United States for decades in investment in machinery and equipment and intellectual property, but in both cases the US is opening up a widening gap.</span><br />
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<span style="color: #b45f06; font-size: large;">What's Behind Canada's Weak Business Investment?</span></h3>
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<span style="font-size: large;">To some extent, Canada's lagging business investment is the result of differences in the industrial structure of the two countries. Canada has abundant natural resources and has long been a leader in capital investment in the extraction and transportation of these resources. When natural resource prices weaken or when governments adopt taxes and regulations that discourage resource development Canada's business investment can weaken quite dramatically. The United States has long been a leader in high technology industries and in the implementation of new technologies to increase business productivity and efficiency. As the pace of technological development accelerates, the US seems to be widening and deepening its advantage in business investment in both machinery and equipment and intellectual property.</span><br />
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<span style="font-size: large;">While industrial structure is important, the influence of government policies can also be very important. Some recent policy developments in the US and Canada clearly seem to have tilted incentives toward higher investment in the US and weaker investment in Canada.</span><br />
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<ul>
<li><span style="font-size: large;"><span style="color: #b45f06;">Corporate Tax:</span> The Trump Administration has lowered corporate tax rates and encouraged repatriation of foreign profits. Canada has, so far, left its corporate tax rates unchanged. In 2017, the federal government raised the ire of small business by suggesting that they were not paying their "fair share" or taxes, before backing down on proposed changes.</span></li>
<li><span style="font-size: large;"><span style="color: #b45f06;">Carbon Tax:</span> The Government of Canada introduced a carbon tax of C$10 per tonne in 2018, rising to C$50 per tonne by 2022. The Trump Administration has pulled out of the Paris Climate Accord and the President has tweeted "I will not support or endorse a carbon tax!"</span></li>
<li><span style="font-size: large;"><span style="color: #b45f06;">Regulation:</span> President Trump has instructed the Environmental Protection Agency to cut regulations on industry and speed up decisions on permits. In Canada, environmental regulations have been tightened and the process to gain approval for pipelines and other energy projects has been made more complicated and time-consuming (see <a href="https://nationalpost.com/opinion/john-ivison-canadas-oil-industry-strains-to-go-forward-while-government-holds-it-back" target="_blank"><span style="color: #b45f06;">here</span></a>).</span></li>
<li><span style="font-size: large;"><span style="color: #b45f06;">Trade Policy:</span> The Trump Administration has: </span></li>
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<li><span style="font-size: large;">demanded major changes to NAFTA which are unacceptable to Canada (and Mexico), thereby leaving negotiations in limbo; </span></li>
<li><span style="font-size: large;">imposed a 20% duty on Canadian softwood lumber after the US Commerce Department ruled that Canada was unfairly subsidizing the industry (a claim made many times in the past but never upheld under WTO or NAFTA dispute settlement procedures); </span></li>
<li><span style="font-size: large;">implemented 25% tariffs on steel and aluminum imports on "national security" grounds, refusing to exempt Canada, a close ally; </span></li>
<li><span style="font-size: large;">threatened 25% tariffs on all auto imports, using the same "national security" justification. </span><span style="font-size: large;"> </span></li>
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<span style="font-size: large;">Trump’s tax and regulatory moves and the uncertainty generated by his trade policies have discouraged business investment in key Canadian goods producing industries. Meanwhile Trudeau’s attempts to tighten small business tax rules and the introduction of new regulatory obstacles to pipeline building and other energy projects have curtailed Canada’s future ability to get oil to export markets, depressed prices of Canadian crude and </span><span style="font-size: large;">discouraged investment</span><span style="font-size: large;">. </span><br />
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<span style="font-size: large;">The net result has been to tilt incentives to invest away from Canada and in favour of the United States. The comparative charts shown above of US and Canadian business investment-to-GDP provide strong evidence that this is the case. Further supporting evidence is provided by </span><span style="font-size: large;">the chart below, which shows Canada's</span><span style="font-size: large;"> foreign direct investment flows.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-uUR7zzz_y9m1gnHC8L3WyAJRMFn18cfVYqB7Kr8xtdU0bhoLwZOP9WEPlciQ2Y_VYEolO0Z_CjEhYkxxHHyMpKWKzGdBZX0XwOJWWgr-NHkL17aOl4VQj_U_XfDKE84vT3dxHf9WhoA/s1600/Canada+FDI.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="570" data-original-width="1023" height="356" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-uUR7zzz_y9m1gnHC8L3WyAJRMFn18cfVYqB7Kr8xtdU0bhoLwZOP9WEPlciQ2Y_VYEolO0Z_CjEhYkxxHHyMpKWKzGdBZX0XwOJWWgr-NHkL17aOl4VQj_U_XfDKE84vT3dxHf9WhoA/s640/Canada+FDI.png" width="640" /></a></div>
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<span style="font-size: large;">The chart clearly shows that while Canadian direct investment abroad is near its' 20-year highs, foreign direct investment flows into Canada have fallen toward 20-year lows. US, Canadian and other foreign companies have a choice as to which side of the border to invest. They are increasingly choosing to invest in the US. The attraction of lower corporate taxes and reduced regulation combined with punitive US tariffs and uncertainty over the future of NAFTA provide powerful incentives to make capacity-expanding investment in the US, not in Canada.</span><br />
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<span style="color: #b45f06; font-size: large;">What is Canada's Response?</span></h3>
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<span style="font-size: large;">So far, Canada has not responded effectively to Trump's tax and regulatory moves. On corporate taxes, the 2018 Federal Budget provided neither action nor a plan to revise Canada's corporate income tax, which prior to Trump's changes, had been relatively attractive. </span><br />
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<span style="font-size: large;">The federal government has not budged on its' plan to enforce a Canada-wide carbon tax, but provincial governments in Saskatchewan and Ontario oppose the plan and a change of government in Alberta would add a third important opponent, making it difficult for the federal government to implement its' carbon tax plan. Uncertainty over the future of carbon taxes remains a negative for business investment.</span><br />
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<span style="font-size: large;">On regulatory measures, the Trudeau government, after allowing a dysfunctional regulatory process to cause the Northern Gateway Pipeline and the Energy East Pipeline projects to die, approved the Trans-Mountain Pipeline. However, because of protests by the Government of British Columbia, environmental activists and indigenous groups, the private investor, Kinder Morgan, shelved the project. The Federal Government kept the project on life support by purchasing the Trans Mountain Pipeline from Kinder Morgan for C$4.5 billion and promising to build it. Opponents will still make strong efforts to block the project, leaving Canada with insufficient capacity to get its' oil to world markets.</span><br />
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<span style="font-size: large;">On trade policy, the federal government has chosen to retaliate against Trump's steel and aluminum tariffs with and equal value of tariffs on a range of US imports, a move which could provoke Trump into further escalating the trade war. Trump has shot Canada in one foot with his tariffs and duties on lumber, steel and aluminum and his threats of tearing up NAFTA and imposing tariffs on autos. Trudeau has shot Canada in its' other foot by imposing tariffs on US goods consumed by Canadians and his rhetoric that Canada "will not be bullied", which has contributed to the standstill in NAFTA negotiations. Let's be clear: Trump's trade policies and threats are dangerous and, if carried out, pose a clear risk to the global growth. But retaliation by US trading partners only increases that risk.</span><br />
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<span style="color: #b45f06; font-size: large;">Is Canada Operating at Full Capacity?</span></h3>
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<span style="font-size: large;">It seems clear to me that Canada's economy is suffering from an investment drought. While unemployment is low by historical standards, weak business investment is resulting in many Canadians working at jobs well below their potential. Self employment is at a record level. Young people have great difficulty finding jobs that match their education and qualifications. Higher levels of business investment would surely create more full time private sector employment and stronger GDP growth. Traditional measures may suggest that Canada is near full capacity, but in my view, it is nowhere near full potential.</span><br />
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<span style="font-size: large;">I am hopeful, however, that the next few years will see Canadian voters electing governments more attuned to the necessity of building a positive investment climate. Change is already underway in Ontario and is pending in Alberta. Only when federal and provincial governments begin working together on a comprehensive strategy to improve the climate for business investment will Canada reach its' potential.</span><br />
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<span style="font-size: large;">In the meantime, tightening monetary policy is unlikely to improve Canada's economic prospects. </span><span style="font-size: large;">Bank of Canada tightening in r</span><span style="font-size: large;">esponse to politically motivated spikes in minimum wages or to temporary upward pressure on Canadian inflation from US and Canadian tariff hikes is clearly inappropriate. Until Canada is able to bring about a lasting improvement in its' investment climate, a Bank of Canada monetary policy strategy of standing pat while the US Fed tightens monetary policy more aggressively would tend to weaken the Canadian dollar, thereby providing a boost to our export competitiveness and a needed adjustment cushion the blow from US protectionism. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-703576349402069352018-01-03T13:55:00.002-08:002018-01-03T13:55:25.274-08:00Global ETF Portfolios: 2017 Returns for Canadian Investors<span style="font-size: large;">For the first time in seven years, the global economy outperformed expectations and the result was solid returns for Global ETF portfolios held by Canadians. At the end of 2016, the consensus among global strategists was for quite modest equity and bond market returns, consistent with consensus views that the US Fed would push up interest rates, thereby depressing expected bond returns, and skepticism that newly-elected President Trump could get his election promises through Congress, depressing expected equity returns.</span><br />
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<span style="font-size: large;">The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavor, we track various portfolios made up of different combinations of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios. </span><br />
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<span style="font-size: large;">Since we began monitoring our Global ETF portfolios at the end of 2011, we have found that the global portfolios have all vastly outperformed a simple all-Canada 60/40 portfolio. In 2016, we saw a reversal, but the trend resumed in 2017.</span><br />
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<span style="font-size: large;">A stay-at-home Canadian investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 2017 total return (including reinvested dividend and interest payments) of 7.0% in Canadian dollars. This was half of the 13.9% gain generated by the same portfolio in 2016. Two of our global ETF portfolios outperformed the all-Canadian portfolio, while two others underperformed. </span><br />
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<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 2017</span></h3>
<span style="font-size: large;">In 2017, with the CAD appreciating almost 7% against USD but depreciating almost 6% against the Euro, the best global ETF returns for Canadian investors were in global equities. The worst returns were in US bonds. The chart below shows 2017 returns, including reinvested dividends, in CAD terms, for the ETFs tracked in this blog. The returns are shown for the full year (green bars) and for the "Great Unwind" period following a coordinated move by central banks in early-June to signal a reduction in the extraordinary monetary ease that had been in place since the Great Financial Crisis of 2008-09.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhb52EiQ3yL6gA0EEXcQn5kv2S5VkKXeSj_3B1Z4IxPqcwqTLL9ZDndMy3P36Q0t2L0FfmIw4hKBubOB13JWr2NfhFXW-nJWcGNdR6b4Nz2AzyE7nQjXwSB0ZNLgERZULyangFEuV8lYWk/s1600/Global+ETF+Returns+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="933" data-original-width="1394" height="428" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhb52EiQ3yL6gA0EEXcQn5kv2S5VkKXeSj_3B1Z4IxPqcwqTLL9ZDndMy3P36Q0t2L0FfmIw4hKBubOB13JWr2NfhFXW-nJWcGNdR6b4Nz2AzyE7nQjXwSB0ZNLgERZULyangFEuV8lYWk/s640/Global+ETF+Returns+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">Global ETF returns varied widely across the different asset classes in 2017. In CAD terms, 14 of 19 ETFs posted gains over the full year, while 5 posted losses. </span><br />
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<span style="font-size: large;">The best gains were in the Emerging Market equity ETF (EEM) which returned a robust 28.4% </span><span style="font-size: large;">in CAD terms</span><span style="font-size: large;">. The Japanese Equity ETF (EWJ) was second best, returning 16.9%, followed closely by the Eurozone equity ETF (FEZ), which returned 16.8%. The S&P500 ETF (SPY) returned 13.9% in CAD terms, while the Canadian equity ETF (XIU) returned 9.6%. </span><br />
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<span style="font-size: large;">The worst performers were the US Inflation-linked government bond ETF (TIP), which returned -3.7% in CAD terms. Other losers were the Long-term (10-20yr) US Treasury Bond (TLH), the US High-Yield Bond (HYG) and the US Investment Grade Corporate Bond (LQD). The losses on these bond ETFs occurred in the period of the Great Unwind.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance for 2016</span></h3>
<span style="font-size: large;">In 2017, the global ETF portfolios tracked in this blog posted solid returns in CAD terms when USD currency exposure was left unhedged and even stronger returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkrLOvFsmQe7oSaC_NnTjET0G6ROophJ9-_ZPo6_vP3nAD4C3b9T6XtauLLJKxhGFPwUSExL8b2eS53L8F1cnxJEl3-kNZ7ZHaH-FGpwnFsIrv7mtBl0IXsmxz3X-gn8na3V8iwuOX1pw/s1600/Global+ETF+Portfolio+returns+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="739" data-original-width="1342" height="352" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkrLOvFsmQe7oSaC_NnTjET0G6ROophJ9-_ZPo6_vP3nAD4C3b9T6XtauLLJKxhGFPwUSExL8b2eS53L8F1cnxJEl3-kNZ7ZHaH-FGpwnFsIrv7mtBl0IXsmxz3X-gn8na3V8iwuOX1pw/s640/Global+ETF+Portfolio+returns+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">A simple Canada only 60% equity/40% Bond Portfolio returned 7.0%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 10.4% in CAD terms when USD exposure was left unhedged, and 13.4% 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 8.2% if unhedged, and 11.4% if USD hedged.</span><br />
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<span style="font-size: large;">Risk balanced portfolios underperformed in 2017 if left unhedged, but performed well if USD exposure was hedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a 5.3% in CAD terms if USD-unhedged, but had a strong return of 13.6% 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, returned 5.8% if USD-unhedged, but 11.0% if USD-hedged.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Four Key Events of 2017</span></h3>
<span style="font-size: large;">In my view, there were four key policy developments that left a mark on Canadian portfolio returns in 2017. The first was the Bank of Canada's poorly telegraphed decision to raise the policy rate. The second was the loosely coordinated move by central banks in June to signal an unwinding of monetary stimulus (at different speeds), which contributed to divergences in relative equity and bond market performances across the major regions. The third was the US Congress' inability to repeal ObamaCare followed by its surprising success in passing sweeping, business-friendly tax reforms in December. The fourth was the Trump Administration's decision to focus its trade policy attention on its NAFTA grievances rather than its complaints about its unbalanced trade with China and other countries. Geopolitical stress associated with North Korea's defiant pursuit of nuclear weapons capable of striking the mainland US also played a role. The impact of these developments can be seen in the chart below which tracks weekly portfolio returns over the course of 2017. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuhXa_w91_HHFEgyQKOEZ-xih4_SHR3aoQOaY7-eTdKVx0mhyphenhyphenTOEceyB2JikgJ5QWh_m3ohazq-1IOneFDQVfXUw7MBNMcCW0_W6GDr-3e7AsyfVS4_E-ZuJmaelsJTE02bTH2CiJQosA/s1600/Global+ETF+Portfolio+Weekly+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="789" data-original-width="1075" height="468" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuhXa_w91_HHFEgyQKOEZ-xih4_SHR3aoQOaY7-eTdKVx0mhyphenhyphenTOEceyB2JikgJ5QWh_m3ohazq-1IOneFDQVfXUw7MBNMcCW0_W6GDr-3e7AsyfVS4_E-ZuJmaelsJTE02bTH2CiJQosA/s640/Global+ETF+Portfolio+Weekly+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">After stumbling through Trump's inauguration, portfolio returns were strong into early June. Then "The Great Unwind" began, as within short order the ECB, BoC, Fed and BoE one after another announced less dovish/more hawkish forward guidance and policy rate actions. ECB President Draghi mused about reducing bond purchases. The Bank of Canada, which had talked of the possibility of cutting rates in January, did a quick U-turn and signalled an early rate hike which came in July. In a well-telegraphed move, the Fed raised the Fed Funds target on June 14 and discussed plans to reduce its balance sheet. After cutting rates following the 2016 Brexit vote, BoE Governor Carney signalled the need to raise rates despite the ongoing uncertainty around the Brexit negotiations. The net result of the central banks' Great Unwind guidance was to push up bond yields and push down the US dollar.</span><br />
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<span style="font-size: large;">The impact on portfolio returns is clearly shown in the above chart. All portfolios suffered from early June through Labour Day. The Canadian dollar surged as much as 10% and bond ETFs faltered. This hit the global risk balanced portfolios hard, with the Leveraged RB portfolio taking the biggest hit. By Labour Day, with North Korean tensions at their peak, with the US Congress' failure to repeal ObamaCare, and with dim prospects for meaningful tax reform, year-to-date returns for Canadian investors in Global ETF portfolios had shrunk from the 6 to 8% range in early June to the +2% to -2% range. </span><br />
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<span style="font-size: large;">The final four months of 2017 saw the losses recouped. Trump cut a deal with Democrats to avoid a government shutdown. US-North Korean tensions peaked without further escalation. Global growth continued to surprise on the upside, but inflation failed to accelerate. ECB and BoJ asset purchases continued apace. US tax reform negotiations gained momentum and, though messy as usual, culminated with the passage of the most sweeping tax overhaul since Ronald Reagan.</span><br />
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<span style="font-size: large;">Meanwhile, after two rate hikes in July and September, the Bank of Canada adopted a more cautious stance. With the economy slowing and NAFTA negotiations going nowhere, the Canadian dollar weakened a bit in 4Q17. The result was a strong recovery in global ETF portfolio returns led by US, Japanese and Emerging Market equities.</span><br />
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<span style="color: #b45f06; font-size: large;">Looking Ahead </span></h3>
<span style="font-size: large;">As we enter 2018, the interesting question is whether "The Great Unwind" of unconventional monetary policy will proceed and possibly pick up pace. The results of 2017 suggest that in periods when withdrawal of central bank stimulus accelerates, bond yields tend to rise and currency moves tend to reflect how aggressively central banks change their guidance.</span><br />
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<span style="font-size: large;">With the most optimistic consensus outlook on global growth in years, it is ironic that the best hope for strong Global ETF portfolio performance for Canadian investors in 2018 would be for Canadian growth and inflation to underperform expectations, thereby allowing the Bank of Canada to withdraw monetary ease more slowly than other major central banks.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-21656867948323812692017-12-18T19:03:00.000-08:002017-12-26T07:44:53.686-08:00Biggest Global Macro Misses of 2017<span style="font-size: large;">As the year comes to a close, it is time to review how the macro consensus forecasts for 2017 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 forecasts and compare them with what we now know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move -- sometimes dramatically -- when 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. 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 2017 investment returns and to assess whether they are sustainable.</span><br />
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<span style="color: #b45f06; font-size: large;">Real GDP</span></h3>
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<span style="font-size: large;">In 2017, for the first time in years, forecasters underestimated global real GDP growth. Average real GDP growth for the twelve countries we monitor is now expected to be 3.6% compared with a consensus forecast of 3.3%. In the twelve economies, real GDP growth exceeded forecasters' expectations in nine and fell short of expectations in just two. The weighted mean absolute forecast error for 2016 was 0.43 percentage points, down slightly from the 2016 error.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjGX3MrhfAziPLBT4N2Ah1YwpMIahAVB6y4wzj8SYIEL-C0bzIpSlf8LS_kEt6PJw5y72kZjF3HoW23G1Z28PNmm9m6BsMTPt59WUKhwtnbVYS7NweJGeHYhmhbSXHwpkyhLkXLmPOpV4/s1600/Real+GDP+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="630" data-original-width="1282" height="314" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjGX3MrhfAziPLBT4N2Ah1YwpMIahAVB6y4wzj8SYIEL-C0bzIpSlf8LS_kEt6PJw5y72kZjF3HoW23G1Z28PNmm9m6BsMTPt59WUKhwtnbVYS7NweJGeHYhmhbSXHwpkyhLkXLmPOpV4/s640/Real+GDP+Misses+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">Based on current estimates, 2017 real GDP growth for the US exceeded the December 2016 consensus by 0.2 percentage points compared with a 0.8 downside miss in 2016. The biggest upside misses for 2017 were for Canada (+1.2 pct pts), Eurozone (+0.9), Korea (+0.9), China (+0.4) and Japan (+0.4). India's real GDP undershot forecasts by 0.6 pct pts and Australia by 0.4. On balance, it was the first year in seven that global growth exceeded consensus expectations.</span><br />
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<span style="color: #b45f06; font-size: large;">CPI Inflation</span></h3>
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<span style="font-size: large;">Inflation forecasts for 2017 were, once again, too high. Average inflation for the twelve countries is now expected to be 2.2% compared with a consensus forecast of 2.5%. Eight 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 0.58 percentage points, a much larger average miss than last year.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfdGH1Z4iZM0AvWnlp47ZwzYqUnkTUGqqhC2zjVJRpD4H-beGokCi7k47nyWgGEYon635ZLyrW5SmLTLnFZaLQkYktlkBSmcKQyYIn3KZUw9vGhoOZ4kg24RezAQxd8ltt_iXB5gv-4wg/s1600/Inflation+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="639" data-original-width="1287" height="316" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfdGH1Z4iZM0AvWnlp47ZwzYqUnkTUGqqhC2zjVJRpD4H-beGokCi7k47nyWgGEYon635ZLyrW5SmLTLnFZaLQkYktlkBSmcKQyYIn3KZUw9vGhoOZ4kg24RezAQxd8ltt_iXB5gv-4wg/s640/Inflation+Misses+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">The biggest downside misses on inflation were in Russia (-2.4 pct pts), Brazil (-1.1), China (-0.7), and Canada (-0.6). The biggest upside miss on inflation was in Mexico (+2.7 pct pts).</span><br />
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<span style="color: #b45f06; font-size: large;">Central Bank Policy Rates</span></h3>
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<span style="font-size: large;">In 2017, for the first time in many years, e</span><span style="font-size: large;">conomists' forecasts of central bank policy rates were too low.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgtpkcrYe3YDlmPRIwAcH3bE4DRxZTF9hd3o82zeSdcwmJEeNxwhmqj0bOrDpMsebOWOnpBKCutzwCsu89qWGC46m1QiR1111VyEkgTFtLfpEhVubSANX8kNGM2afqJEyzbAyNzu-FtWNM/s1600/Policy+Rate+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="646" data-original-width="1275" height="324" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgtpkcrYe3YDlmPRIwAcH3bE4DRxZTF9hd3o82zeSdcwmJEeNxwhmqj0bOrDpMsebOWOnpBKCutzwCsu89qWGC46m1QiR1111VyEkgTFtLfpEhVubSANX8kNGM2afqJEyzbAyNzu-FtWNM/s640/Policy+Rate+Misses+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">In the DM, the Fed hiked the Fed Funds rate three times, more than the consensus expected. The ECB had been expected to keep its Refi rate unchanged, but surprised forecasters by lowering it to -0.4%. The Bank of Canada and the Bank of England had been expected to leave rates unchanged in 2017, but the BoC unexpectedly hiked twice and the BoE hiked once. In Australia, the consensus leaned toward a rate cut in 2017, but the RBA stayed on hold. The Bank of Japan met expectations and stayed on hold at -0.1%. In the EM, the picture was more mixed. Brazil's central bank was able to cut its policy rate much more than expected as inflation eased, while Russia was also able to cut its policy rate a bit more than expected. In China, the PBoC stayed on hold, as expected, while India's RBI eased 25bps, also in line with expectations. Mexico extended the trend of late 2016, tightening 100 bps more than expected as inflation rose sharply in delayed response to the weakening of the Mexican Peso as NAFTA came under heavy fire from the Trump Administration. </span><br />
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<span style="color: #b45f06; font-size: large;">10-year Bond Yields</span></h3>
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<span style="font-size: large;">In six of the twelve economies, 10-year bond yield forecasts made one year ago were too high. Weaker than expected inflation combined with aggressive bond buying by the the ECB pulled 10-year yields down in most DM countries compared with forecasts of rising yields made a year ago.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB5Q8OsW2uOV38X2a7Yhf1VPBGbnS9C7kEh2vXKJyy2D_U_t-gJueivMcEehZDnS9LYd52pE8vJ4LmPc70aZFAj8VmZgxu13RnCUZdyzAgOkCXe2VCopzHjAdIR0q8aJiF2bYgmFovnX8/s1600/Bond+Yield+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="656" data-original-width="1285" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjB5Q8OsW2uOV38X2a7Yhf1VPBGbnS9C7kEh2vXKJyy2D_U_t-gJueivMcEehZDnS9LYd52pE8vJ4LmPc70aZFAj8VmZgxu13RnCUZdyzAgOkCXe2VCopzHjAdIR0q8aJiF2bYgmFovnX8/s640/Bond+Yield+Misses+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">In four of the six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.30 percentage points. The biggest misses were in the UK (-0.48 pct. pt.), US (-0.35), Eurozone (proxied by Germany, -0.34) and Australia (-0.30). In the EM, the picture was mixed as bond yields were lower than forecast where inflation fell more than expected, in Brazil (-2.05 pct pts) and Russia (-1.54). Bond yields were higher than expected in China, India and Mexico.</span><br />
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<span style="color: #b45f06; font-size: large;">Exchange Rates</span></h3>
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<span style="font-size: large;">All of the major currencies (with the exception if the UK sterling) were stronger than expected against the US dollar. The weighted mean absolute forecast error for the 11 currencies versus the USD was 7.7% versus the forecast made a year ago, a larger error than last year.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiXowNECHF6CCBh5l7ZVN6hyphenhyphenuiiuym3X5zMldRUbIpaZh91wbPgYuBZkTBZt-Ymt7BhvQOGoGOeiHVk8FF6eDxMq9REqtsAgtmuXBuflTIh5izYVbrb_t8khOhI19C1bO5B4_V3x6CjWuM/s1600/FX+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="637" data-original-width="1283" height="316" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiXowNECHF6CCBh5l7ZVN6hyphenhyphenuiiuym3X5zMldRUbIpaZh91wbPgYuBZkTBZt-Ymt7BhvQOGoGOeiHVk8FF6eDxMq9REqtsAgtmuXBuflTIh5izYVbrb_t8khOhI19C1bO5B4_V3x6CjWuM/s640/FX+Misses+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">The USD was expected to strengthen following the election of Donald Trump as President. Trump's criticism of the Fed during the 2016 election (implying that Fed Chair Janet Yellen would not be reappointed) and his plans for deregulation and fiscal stimulus had most forecasters expecting the USD to hold steady or strengthen against most currencies. As it turned out, delays in implementation of Trump's promises, hesitation by the Fed, unexpected tightening by some other central banks and ebbing political uncertainties in emerging countries saw the USD weaken against all currencies with the exception of Sterling, which struggled under the weight of Brexit uncertainty. </span><br />
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<span style="font-size: large;">The biggest FX forecast misses were for the Euro (which was 10.8% stronger than expected), Russian Ruble (+10.1%) and Korean Won (+11.0%). The Canadian Dollar (+7.7%) and the Mexican Peso (+6.4%) were stronger than expected, despite NAFTA worries, as the central banks of both countries tightened more than forecasters had expected. China, India and Brazil also saw greater than expected currency strength. </span><br />
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<span style="color: #b45f06; font-size: large;">Equity Markets</span></h3>
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<span style="font-size: large;">A year ago, equity strategists were optimistic that North American stock markets would turn in a modest, unspectacular positive performance in 2017. News outlets gather forecasts from high profile US strategists and Canadian bank-owned dealers. As shown below, those forecasts called for 2017 gains of 6.0% for the S&P500 and 4.3% for the S&PTSX Composite.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhLhTY2QdR3uiziAwT93kLpXGxuwVy5QrlU4OB-YEbif-xiEHmriZzghKxT5zdz7goaiuLz1xa3JpTaZJ2OqeHHKqkRFPHLjIzY3aVO5X8l9JwBGAdmrK9ZlnXmqShTUAKLivlpp1l0JgA/s1600/Equity+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"></span></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdquPfKpoRsEuIaDRoR2HhfhaV4pvK0eJMcyytOoneecZiRRlEgX-YOIzTVHJx8pCS368vkhcifVDIr14qUDJYQnA5Okd0YeDmieiiUbmoQOsZ1fU6DCyAbri_odX1t0agqcR5g04tYdI/s1600/Equity+Misses+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="631" data-original-width="1271" height="316" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdquPfKpoRsEuIaDRoR2HhfhaV4pvK0eJMcyytOoneecZiRRlEgX-YOIzTVHJx8pCS368vkhcifVDIr14qUDJYQnA5Okd0YeDmieiiUbmoQOsZ1fU6DCyAbri_odX1t0agqcR5g04tYdI/s640/Equity+Misses+2017.png" width="640" /></a></div>
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<span style="font-size: large;">However, global real GDP growth surprised on the upside and global inflation surpassed on the downside, both misses being positive for equities.</span><span style="font-size: large;"> </span><span style="font-size: large;">As of December 26, 2017, the S&P500, was up 19.9% year-to-date (not including dividends) for an error of +13.9 percentage points. The S&PTSX300 was up a more modest 5.8% for an error of +1.5 percentage points.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUzejCdSVvZ7OP5QVN51teF_tD1uIr3tMFU6b0ASytNYIXnhkIPujCSvvoEm63vtkNpSlj2DgtFs66zGFNSvzxBq9uchSTFHUPQ5shqCv92ywJpaYrHNnEomXjdrkNSUsuyarhVw-SzBc/s1600/Actual+Equities+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="655" data-original-width="1285" height="326" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUzejCdSVvZ7OP5QVN51teF_tD1uIr3tMFU6b0ASytNYIXnhkIPujCSvvoEm63vtkNpSlj2DgtFs66zGFNSvzxBq9uchSTFHUPQ5shqCv92ywJpaYrHNnEomXjdrkNSUsuyarhVw-SzBc/s640/Actual+Equities+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">Globally, stock market performance (in local currency terms) was impressive. Japan and most emerging markets (with the exception of Russia) posted the best gains. Canada and Mexico were laggards. </span><br />
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<span style="color: #b45f06; font-size: large;">Investment Implications</span></h3>
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<span style="font-size: large;">In 2017 global macro forecast misses were quite different from those of recent years. Real GDP growth exceeded expectations for the first time in seven years. CPI inflation continued to surprise on the downside, but several major central banks tightened more than expected despite weak inflation. However, the impact of higher than expected policy rates on bond yields was more than offset by the ECB's move to a significantly negative policy rate combined with continued large scale bond purchases. Consequently, even though major central banks tightened more than expected, bond yields came in lower than expected. And even though the US Fed led the move to tighten, the USD was weaker than expected against all of the major currencies expect UK Sterling. </span><br />
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<span style="font-size: large;">Stronger than expected global growth, lower than expected inflation, and a smaller than expected rise in bond yields boosted equity performance in virtually all markets. US equities posted double-digit returns for a second consecutive year. The combination of better than expected real GDP growth and stimulative monetary policy boosted Japanese stocks and European stocks. Strong global growth and reduced political uncertainties facing Brazil and Russia helped lift Emerging Market equities to robust gains. In China, equity prices rebounded as Trump's protectionist campaign rhetoric against China was moderated by the US need for Chinese cooperation against North Korea's nuclear threat. Instead, Trump's protectionism was focussed on renegotiating NAFTA with Canada and Mexico, whose stock markets underperformed.</span><br />
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<span style="font-size: large;">For Canadian investors, the stronger than expected 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 winners for unhedged Canadian investors were Eurozone, Japanese and Emerging Market equities.</span><br />
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<span style="font-size: large;">The outperformance globally diversified portfolios over stay-at-home Canadian portfolios reasserted itself in 2017. </span><span style="font-size: large;">As 2018 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. </span><span style="font-size: large;">While forecasters' optimism about global growth appears high, 2018 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. The 2017 surprises, higher than expected growth and lower than expected inflation are now being built in to 2018 views. This actually increases the chances of disappointments that are negative for equities and other risk assets. With unconventional monetary stimulus being questioned and central banks belatedly beginning to focus on containing debt growth rather than hitting inflation targets, the scope for unfriendly surprises is rising.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-38197910888772555402017-10-12T19:54:00.000-07:002017-10-12T19:54:56.673-07:00Canada's Credit Cycle Downturn Is Coming<span style="font-size: large;">In the aftermath of the Great Financial Crisis (GFC), it was widely acknowledged that traditional macroeconomic models of aggregate demand and aggregate supply had failed to provide early warning signals of the financial collapse that was to come. </span><br />
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<span style="font-size: large;">While most economists focus on the business cycle, identified by peaks and troughs in real GDP, they have had remarkably limited success in forecasting when recessions will occur. Following the GFC, some analysts have shifted their attention toward the financial side of the economy and longer-term credit cycles. </span><br />
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<span style="font-size: large;">Ray Dalio of Bridgewater Associates has become famous, not only for building the world's biggest hedge fund, but also for his analysis of <a href="https://www.youtube.com/watch?v=PHe0bXAIuk0" target="_blank"><span style="color: #b45f06;">How the Economic Engine Works</span></a>, which is founded on the concepts of the <b>short-term debt cycle</b> (equivalent in Dalio's view to the business cycle) and the <b>long-term debt cycle</b> (equivalent to booms and busts in financial markets which trigger bubbles and busts in asset markets).</span><br />
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<span style="font-size: large;">John Geanakopolos of Yale University has identified what he calls the <b><a href="https://economics.mit.edu/files/3636" target="_blank"><span style="color: #b45f06;">leverage cycle</span></a></b>. As the <a href="https://www.wsj.com/articles/SB125720159912223873" target="_blank"><span style="color: #b45f06;"><i>Wall Street Journal</i> reported</span></a>:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">Geanakopolos theorized that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors.... Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.</span></blockquote>
<span style="font-size: large;">Claudio Borio, Head of the Bank for International Settlements (BIS) Monetary and Economic Department, analyses what he refers to as the <b>financial cycle</b>. As <a href="https://www.economist.com/blogs/freeexchange/2012/12/reforming-macroeconomics" target="_blank"><span style="color: #b45f06;"><i>The Economist</i> magazine quoted Borio</span></a>:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">In the environment that has prevailed for at least three decades now, just as in the one that prevailed in the pre-WW2 years, it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. This calls for a rethink of modelling strategies. And it calls for significant adjustments to macroeconomic policies.</span></blockquote>
<span style="font-size: large;">According to Borio, the financial cycle can be understood as a sequence of "self-reinforcing interactions between perceptions of value and risk which translate into booms followed by busts". The financial cycle has several salient features that often cause it to be ignored by mainstream economists. First, it has a much lower frequency than a typical business cycle. Instead of going from peak to trough every 5-7 years, the financial cycle can take decades. Patterns of economic activity on both the upside and downside simply do not make sense unless the high-frequency business cycle is overlaid on top of the slower-moving financial cycle. Second, the amplitude of the financial cycle is very wide compared to the amplitude of the normal business cycle. This combination means that the financial cycle produces sustained booms and deep downturns.</span><br />
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<span style="font-size: large;">While Dalio's debt cycle, Geanakopolos' leverage cycle, and Borio's financial cycle use different names, all three are highlighting cycles, not in aggregate spending or GDP, but in debt, leverage or credit growth that create self-reinforcing accelerations or decelerations in financial and economic activity. </span><br />
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<span style="font-size: large;">Personally, I prefer the term <b>credit cycle</b> which harkens back to Hyman Minsky's theory of financial instability and the view that the credit cycle is the fundamental process driving the business cycle.</span><br />
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<span style="font-size: large;">While much has been written about the credit cycle in global financial circles, there has been unfortunately little acknowledgement or application of this recent strand of research to Canadian economic forecasting or policy-making. This relative lack of attention is more striking because, since the GFC, Canada has experienced a credit boom of epic proportions. </span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Canada's Credit Cycle</span></h3>
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<span style="font-size: large;">For over a decade, analysts at the BIS and elsewhere have compiled methodologically consistent historical credit data for a wide range of advanced and emerging economies. In recent reports, the BIS have employed its measure of the <b><a href="http://www.bis.org/publ/qtrpdf/r_qt1403g.htm" target="_blank"><span style="color: #b45f06;">credit-to-GDP gap</span></a></b> (or Credit Gap) to identify countries a that are subject to heightened risk of financial crisis. The Credit Gap is defined as the difference between the credit-to-GDP ratio and its long-term trend. The two charts below show the credit-to-GDP ratio and the Credit Gap for Canada with the same measures for the United States shown for comparison.</span><br />
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<span style="font-size: large;">In both countries, the credit-to-GDP ratios have risen steadily over the decades. In both countries, the ratio rose from about 75% of GDP in the late 1950s to about 170% by 2007, at the onset of the GFC. Since then, the ratios have diverged sharply, with Canada continuing to increase leverage to a peak of 219% of GDP in 3Q:16, while the US deleveraged to a ratio just over 150% over the same period. The chart clearly shows that after tracking each other quite closely from the mid-1950s to the mid-1970s, leverage cycles in the two countries have become much less closely linked. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhF8ZTVKQOyw1Pz0VfU6OJtKGd60RS_TB4anNJTSGvFnmuHmkESuGV8tGhRurbkZGyHN3WwKKYXNaEpBxjvaK5lmdD_MV0S899rD7Tidrf_2P0h-eh_FOAzqL4rRYJtW5SeDzxjtqAeFvk/s1600/Credit-to-GDP+Ratio.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="630" data-original-width="971" height="414" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhF8ZTVKQOyw1Pz0VfU6OJtKGd60RS_TB4anNJTSGvFnmuHmkESuGV8tGhRurbkZGyHN3WwKKYXNaEpBxjvaK5lmdD_MV0S899rD7Tidrf_2P0h-eh_FOAzqL4rRYJtW5SeDzxjtqAeFvk/s640/Credit-to-GDP+Ratio.png" width="640" /></span></a></div>
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<span style="font-size: large;">The second chart shows the BIS measure of the Credit Gap in the two countries. Since the mid-1970s, while the US has experienced two very pronounced peaks and troughs in its credit gap, Canada has experienced four pronounced peaks and three troughs. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhecoz-engkWtb7kv_gb6_uRZ8jQCCMin1Hw8nX5b_ZCHRC6yGjVxHhpvjVVbAMv4PA0FJ4AdGSKVHnIU4qENjisNeqY1HgTvaxYgiXXCJibZh6Dn3r9UOdNj3OYAmxPdKlsBV2tpagjA4/s1600/Credit-to-GDP+Gap.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="622" data-original-width="975" height="408" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhecoz-engkWtb7kv_gb6_uRZ8jQCCMin1Hw8nX5b_ZCHRC6yGjVxHhpvjVVbAMv4PA0FJ4AdGSKVHnIU4qENjisNeqY1HgTvaxYgiXXCJibZh6Dn3r9UOdNj3OYAmxPdKlsBV2tpagjA4/s640/Credit-to-GDP+Gap.png" width="640" /></span></a></div>
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<span style="font-size: large;">The peaks in the US credit gap occurred in 1987 and 2007. The first peak coincided with the 1987 stock market crash and was an early warning signal of the bursting of the real estate bubble and the S&L Crisis of the early-1990s. The second peak coincided with the peak of the US housing boom and was an early warning signal of the Great Financial Crisis that saw the failures of Bear Stearns and Lehman Brothers.</span><br />
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<span style="font-size: large;">The peaks in Canada's credit gap occurred in 1979, 1991, 2009 and 2016. It is noteworthy that Canada's latest three credit gaps all exceeded the peak levels seen in the US in 1987 and 2007. The peak in 1979 was a precursor to the deep 1981-82 recession. The peak in 1991 followed shortly after a peak in housing prices amid the 1990-91 recession. The peak in 2009, as in 1991, came amid another recession in 2008-09. The apparent peak in 2016, the biggest credit gap ever recorded for Canada, looks to be a precursor to another peak in housing prices which is unfolding as we watch in 2017.</span><br />
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<h3>
<span style="font-size: large;"><span style="color: #b45f06;">Canada's Credit Gap and Real GDP Growth Gap</span> </span></h3>
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<span style="font-size: large;">Whether the 2016 peak in Canada's credit gap is an early warning signal of another recession remains to be seen. But an inspection of how cycles in credit growth line up with cycles in real GDP growth suggests a serious risk that the Canadian economy is on the cusp of at least a sharp slowdown in real GDP growth. </span><br />
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<span style="font-size: large;">The chart below compares Canada's credit gap with its real GDP growth gap. The real GDP growth gap, analogously to the credit gap, can be defined as defined as the difference between real GDP growth and its long-term trend.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgeekRpBUCCoUvKhXAbRUnwj8sa3nkHlhgfi4BQEYj2OJckhkn-D5mqaSlO_MPrS3Mf9U-DiQJyGsRTK8xmKjeGSVwGzx697cGaC6nq7g2IdZvfeZKU6hCVi0MWJMfXmA1aVDiBCncN0I/s1600/Credit+Gap+and+Growth+Gap.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="779" data-original-width="1367" height="364" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgeekRpBUCCoUvKhXAbRUnwj8sa3nkHlhgfi4BQEYj2OJckhkn-D5mqaSlO_MPrS3Mf9U-DiQJyGsRTK8xmKjeGSVwGzx697cGaC6nq7g2IdZvfeZKU6hCVi0MWJMfXmA1aVDiBCncN0I/s640/Credit+Gap+and+Growth+Gap.png" width="640" /></span></a></div>
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<span style="font-size: large;">While this chart doesn't appear to show a close relationship, my calculation is that the levels of peaks and troughs in the credit gap have a 90% correlation with the level of peaks and troughs in the real GDP growth gap. This may sound complicated, but its not. Using all of the peaks and troughs in the credit gap and the real GDP growth gap, it implies that higher credit gap peak levels have been associated with higher real GDP growth gap peaks and lower credit gap trough levels have been associated with lower real GDP growth gap trough levels.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Conclusion</span></h3>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">We apparently have seen a peak in Canada's credit gap in 3Q16 at its highest level ever. We have apparently subsequently seen a peak in the real GDP growth gap in 2Q17, as growth in 3Q17 seems to be slowing sharply. Many commentators have been crowing about Canada's recent growth spurt, but the history of cycles in Canada's credit gap suggests that, far from signalling a sustained acceleration of real GDP growth, the peak in the credit cycle is probably signalling the beginning of what could become a serious growth slowdown in real GDP growth ... or worse. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-29131536751658899262017-07-31T19:08:00.000-07:002017-07-31T19:08:05.315-07:00The Great Unwind: Not So Great For Canadian Investors<span style="font-size: large;">The Great Unwind of extraordinarily accommodative global monetary policy got underway in earnest in June, 2017. Until then, though the Fed had begun reducing monetary ease at the end of 2015, other major central banks had maintained very easy policies. </span><br />
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<span style="font-size: large;">Then, as if on cue, the European Central Bank expressed confidence in the strength of Euro Area growth and mused about reducing its bond purchases (<a href="https://www.nytimes.com/2017/06/08/business/economy/europe-ecb-rates.html" target="_blank">June 8</a>); the Bank of Canada's top officials suddenly executed a U-turn from ruminations about cutting rates in January to contemplating early rate hikes (<a href="http://www.cbc.ca/news/business/loonie-poloz-1.4158299" target="_blank">June 12-13</a>); the Federal Reserve hiked its policy rate and discussed reducing its' $4.5 trillion balance sheet (<a href="http://www.reuters.com/article/us-usa-fed-idUSKBN1952NA" target="_blank">June 14</a>); and Bank of England Governor Mark Carney said the BoE may need to begin raising interest rates and would debate a move in the next few months (<a href="https://www.bloomberg.com/news/articles/2017-06-28/carney-says-boe-may-need-to-start-raising-rates-as-slack-erodes" target="_blank">June 28</a>).</span><br />
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<span style="font-size: large;">Increasing the likelihood that these central bank unwinding moves were coordinated was the Bank for International Settlements Annual Report, released on June 25, titled <i><a href="http://www.bis.org/publ/arpdf/ar2017e4.htm" target="_blank">Monetary Policy: Inching Toward Normalization</a>, </i>which laid out the case for removing monetary stimulus even though inflation remains well below target in virtually all of the major advanced economies.</span><br />
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<span style="font-size: large;">The coordinated central bank (CB) unwinding of monetary stimulus has been widely applauded as a recognition that global growth has strengthened, global slack has diminished and global debt-to-GDP ratios had risen to all-time highs, posing financial stability risks. But despite the fact that unprecedented global monetary policy accommodation had fuelled asset price growth for years, few commentators raised concerns that unwinding monetary policy stimulus might have negative consequences for global asset prices.</span><br />
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<span style="font-size: large;">This post takes a brief look at how the Great Unwind has affected Canadian investors. I do this through the lens of the global ETF portfolios for Canadian investors that I regularly track in this blog.</span><br />
<span style="font-size: large;">The chart below shows year-to-date total returns for these portfolios, in Canadian dollar (CAD) terms.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlpe4f1J2NGjSevs3gBORfHlAZ47xDToecuGFw3QR6JZrwkI99bnpTcfcHBxeE7M8CQ5pmvNWGAPEcvFpEKW6YjkJpd-kjfYj5cz9GUFR9aHU67hyeYz15JJ6aKp5258bjH6Tjd-tdHS4/s1600/Global+ETF+Portfolios+2017.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="906" data-original-width="1079" height="536" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlpe4f1J2NGjSevs3gBORfHlAZ47xDToecuGFw3QR6JZrwkI99bnpTcfcHBxeE7M8CQ5pmvNWGAPEcvFpEKW6YjkJpd-kjfYj5cz9GUFR9aHU67hyeYz15JJ6aKp5258bjH6Tjd-tdHS4/s640/Global+ETF+Portfolios+2017.png" width="640" /></span></a></div>
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<span style="font-size: large;">The chart shows returns for five portfolios: an all-Canadian ETF portfolio (Cdn 60/40) made up of 60% Canadian equities (XIU), 35% Canadian bonds (XBB) and 5% Canadian real return bonds (XRB); a Global 60/40 portfolio including both Canadian and global equity and bond ETFs; a more conservative Global 45/25/30 portfolio made up of 45% global equity ETFs, 25% global bond ETFs and 30% cash, a Global Levered Risk Balanced Portfolio (Gl Lev RB), which uses leverage to balance the expected risk contribution from the Global Market ETFs, and a Global Unlevered Risk Balanced Portfolio (Gl UnL RB), which has less exposure to government bond ETFs, inflation-linked bond ETFs and commodity ETFs than the levered risk balanced portfolio but more exposure to corporate credit ETFs.</span><br />
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<span style="font-size: large;">As is evident from the chart, all of these portfolios performed well into early June, peaking in the week ending June 2. After the ECB signalled its change of direction on June 8, all of the portfolios began to give back their gains. The Global 60/40 portfolio, which had the strongest year-to-date (ytd) gain of 8.2% on June 2, has given back about two-thirds of its gain and was up just 2.9% for the year by the week ended July 28. Hardest hit was the Global Risk Balanced Portfolio, which went from a ytd gain of 8.1% on June 2 to a ytd loss of 1.8% by July 28. The gain in the all-Canadian portfolio, which had struggled to a 2.9% ytd return by June 2, had been erased to a 0.1% loss by July 28.</span><br />
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<span style="font-size: large;">If the global and Canadian economies are faring so much better, why have investment returns for Canadian investors turned so negative in the Great Unwind? The answer is that the swift turnaround in the stance of the BoC caught markets by surprise and caused the Canadian dollar to surge against the US dollar and other currencies. The surge in CAD has imposed losses on unhedged investors in global ETFs denominated in US dollars. As shown in the chart below, every ETF tracked in this blog has experienced negative returns in CAD terms since the CB Unwind began in early June. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQS_9ei4QnR4vuk1Qauwf3KyQ70JxY_I5fJuZlqOfi1QeK_9J0xc-GUWj9RvL4gFrufEjaw0Ku4_gbmAC_oANobbKEwpQrOUl04T8ACbhy3H24Su7wpUGwlSp0xxD_gumLZNRaTfYGaPw/s1600/Global+ETF+Return+CB+Unwind.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="901" data-original-width="1442" height="398" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQS_9ei4QnR4vuk1Qauwf3KyQ70JxY_I5fJuZlqOfi1QeK_9J0xc-GUWj9RvL4gFrufEjaw0Ku4_gbmAC_oANobbKEwpQrOUl04T8ACbhy3H24Su7wpUGwlSp0xxD_gumLZNRaTfYGaPw/s640/Global+ETF+Return+CB+Unwind.png" width="640" /></span></a></div>
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<span style="font-size: large;">The more hawkish BoC stance has also seen Canadian interest rates back up, pushing Canadian bond prices down and causing losses on Canadian bond ETFs. Making matters worse, the Canadian equity ETF (XIU) has been one of the worst performers (in local currency terms) among global equity ETFs since the Great Unwind began, losing 2.4%. While US, Eurozone, Japanese, and Emerging Market ETFs have had better local currency returns, the surge in CAD has meant that these ETFs have experienced even bigger losses than XIU in Canadian dollar terms.</span><br />
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<span style="font-size: large;">Losses on global bond ETFs range from -4.5% to -9.0% in CAD terms since early June. Losses on global, equity ETFs range from -3.3% to -6.4%. Losses on gold and commodity ETFs range from -6.3% to -8.1%. The result is that returns for Canadian investors on globally diversified portfolios have been hammered since the Great Unwind began, reducing or totally erasing the promising gains of the first five months of 2017 as shown in the chart below.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjujUuTN3oheL9fxevoACWUGyzwxMbyeMwcWhXvsnEn48IKr_P1fe0uznRcKJqHexb7MSl-4400hyMQY4aXS0rtgZ2NPcLaV-xyJbFsRtxybFLUyyBsJnhOsF-ByH2AzPY5j5wFiCv_P-w/s1600/Global+ETF+Portfolio+Returns+YTD.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="757" data-original-width="1222" height="396" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjujUuTN3oheL9fxevoACWUGyzwxMbyeMwcWhXvsnEn48IKr_P1fe0uznRcKJqHexb7MSl-4400hyMQY4aXS0rtgZ2NPcLaV-xyJbFsRtxybFLUyyBsJnhOsF-ByH2AzPY5j5wFiCv_P-w/s640/Global+ETF+Portfolio+Returns+YTD.png" width="640" /></a></div>
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<span style="font-size: large;"><br /></span>
<span style="font-size: large;">There is a slight silver lining to the Great Unwind black cloud for Canadian investors. The chart below compares the Great unwind losses for currency unhedged portfolios with those portfolios that were USD-hegded. If foreign ETF holdings were USD-hedged, the globally diversified portfolios would have experienced small gains since June 2, much better performance than the all-Canadian portfolio.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtCFcUDuN6LHKv7Nfk8lskRvNbpZ0twOgzeMsSQbO7LQ3enlL_wHUbG9dEyPenxZ_OGkR2pEN3o4HGFUHiL-qCRbry_t2D-qkFET7iV-1gElLqfcdIrsR-HZSIipw3dwHxlglKH-q8g4c/s1600/Unwind+hedged+vs+unhedged.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="728" data-original-width="1221" height="380" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtCFcUDuN6LHKv7Nfk8lskRvNbpZ0twOgzeMsSQbO7LQ3enlL_wHUbG9dEyPenxZ_OGkR2pEN3o4HGFUHiL-qCRbry_t2D-qkFET7iV-1gElLqfcdIrsR-HZSIipw3dwHxlglKH-q8g4c/s640/Unwind+hedged+vs+unhedged.png" width="640" /></span></a></div>
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<span style="font-size: large;">Unfortunately, most Canadian investors do not fully hedge their foreign currency exposures. Indeed, some large pension funds and the majority of individual investors do not hedge at all. My guess would be that far less than half of Canadians' holdings of C$1.8 trillion of foreign portfolio investments (of which $1.1 trillion are USD-denominated) are currency hedged. Based on this assumption, and on the holdings of Canadian bonds and equities, my back of the envelope estimate of the losses to Canadian investors since the beginning of the Great Unwind in early June would be in the neighbourhood of C$150 billion. </span><br />
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<br />TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-61703952185672479482017-06-25T18:36:00.000-07:002017-06-25T18:36:28.127-07:00How Accurate are the Bank of Canada's Inflation Forecasts?<span style="font-size: large;">The Bank of Canada is an inflation-targeting central bank. It sets monetary policy with an objective of returning the inflation rate to the 2% target within six to eight quarters. Because this is the objective, the Governing Council of the BoC always projects that six to eight quarters from the current period, inflation will be 2%. If it did not do so, it would be admitting <i>either</i> that it cannot achieve the 2% target <i>or</i> that for some special reason it would not be appropriate to attempt to achieve the target. To my recollection, the latter has never happened.</span><br />
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<span style="font-size: large;">Four times a year, the BoC publishes the <i><a href="http://www.bankofcanada.ca/content_type/publications/mpr/?post_type%5B0%5D=post&post_type%5B1%5D=page" target="_blank"><span style="color: #b45f06;">Monetary Policy Report</span></a></i>, in which the Governing Council reveals its projection for inflation over the coming two years. The inflation projection is important because it shapes expectations about the likely future path of the Bank of Canada's policy rate. For example, if the current inflation rate is below the 2% target (as it is currently), but the BoC projects that inflation will return to the 2% target over the next six or twelve months, then there would tend to be an expectation that the BoC would reduce the amount of monetary stimulus over that period.</span><br />
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<span style="font-size: large;">One would expect that the BoC would be expert at projecting inflation. After all, the BoC undoubtedly has the largest number of highly educated economists of any institution in Canada and they are focussed on projecting inflation. The BoC has access to whatever resources are required, including model building capability, as well as input from top academic and private sector advisors. And most importantly, the BoC controls the monetary policy tools that can influence the inflation rate. So it seems reasonable to ask the question: <i>With all of these resources, with a strong government mandate, and with independent control of the policy levers: Can the Bank of Canada accurately project future inflation?</i></span><br />
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<span style="color: #b45f06; font-size: large;">Reviewing the Track Record</span></h3>
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<span style="font-size: large;">To answer the question, we must look at the projections of inflation that the BoC has made. In this post, I review the track record of the current decade, starting in January 2010. This is the period following the Great Financial Crisis (GFC) during which Mark Carney and Stephen Poloz have been the BoC Governors.</span><br />
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<span style="font-size: large;">To conduct the review, I have compiled the projections of inflation made in each <i>Monetary Policy Report</i> since January 2010 and compared the projections with inflation outcomes one year later. I have reviewed the projection accuracy for both Total CPI inflation and Core CPI inflation. Shown below is the actual performance of total and core inflation, shown as quarterly averages since the beginning of 2010. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEik1tR6psQhlxpmCAjxWPByJhseaWVKnwsvTLaXXd1Hn6LrtOQnEugxpttK5X87RbmIIDFKHXAAPCzfP3RzJJnLJYtHxSE3GKwUnl0VmOhqqfQrihyphenhyphenkeAU6BzM7Am7U6VO7M2lZgByXlXg/s1600/Canada+Total+and+Core+Inflation.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="601" data-original-width="944" height="406" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEik1tR6psQhlxpmCAjxWPByJhseaWVKnwsvTLaXXd1Hn6LrtOQnEugxpttK5X87RbmIIDFKHXAAPCzfP3RzJJnLJYtHxSE3GKwUnl0VmOhqqfQrihyphenhyphenkeAU6BzM7Am7U6VO7M2lZgByXlXg/s640/Canada+Total+and+Core+Inflation.png" width="640" /></span></a></div>
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<span style="font-size: large;">Over this period, total inflation has averaged 1.66% and core inflation has averaged 1.73%. Total inflation was below the 2% target 70% of the time (21 out of 30 quarters) and core inflation was below the target level 60% of the time.</span><br />
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<span style="font-size: large;">Now let's look at how accurately the BoC Governing Council projected total and core inflation one year ahead. The charts below show the actual outcomes against the BoC Projections made one year earlier. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkxeL3P3SyWndG-WCNMpzJityvf75aYEH1l6F1EFF0WYyu1XyNIsUfKTxPoVV5JQrKYGLT1LU26keEHJpy6Ry_QjyK5Fol1CX_KqPg6ggb8XTRUwQMLcqlaBD1AraOcHM58kzzFWl4nk4/s1600/Canada+Total+Inflation+Projection.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="611" data-original-width="947" height="204" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkxeL3P3SyWndG-WCNMpzJityvf75aYEH1l6F1EFF0WYyu1XyNIsUfKTxPoVV5JQrKYGLT1LU26keEHJpy6Ry_QjyK5Fol1CX_KqPg6ggb8XTRUwQMLcqlaBD1AraOcHM58kzzFWl4nk4/s320/Canada+Total+Inflation+Projection.png" width="320" /></span></a></div>
<span style="font-size: large;">The chart for total inflation shows that the BoC consistently projected that inflation would return to close to 2%, while the actual outcomes varied significantly, between 0.7% and 3.4%. By my calculation, the average absolute error of the BoC's 1-year forward projections for total inflation has been 0.63 percentage points (ppts) which amounts to 38% of the average inflation rate over the projection period and 90% of the standard deviation of total inflation over the period.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7W9J2iVrrFnhHItP4N6_coN0vp7UI3REItTkxSO46zAkoIJbfQ69bfK1MQ6pOoCx6P_8ADt8BU1lzxK0JreR63Zns0Zl_JaAIGLD0udIH_7gMlvGwP-JQhOfOzfINY9cMybkgSf2vn3w/s1600/Canada+Core+Inflation+Projection.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" data-original-height="611" data-original-width="947" height="206" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7W9J2iVrrFnhHItP4N6_coN0vp7UI3REItTkxSO46zAkoIJbfQ69bfK1MQ6pOoCx6P_8ADt8BU1lzxK0JreR63Zns0Zl_JaAIGLD0udIH_7gMlvGwP-JQhOfOzfINY9cMybkgSf2vn3w/s320/Canada+Core+Inflation+Projection.png" width="320" /></span></a></div>
<span style="font-size: large;">The chart for core inflation shows less variability in both actual outcomes and the BoC's projections. Since the January 2010 <i>MPR</i>, the one-year forward core inflation projection has never varied outside the range of 1.8% to 2.1%. Actual outcomes for core inflation have varied between 1.2% and 2.2%. The average absolute error of the BoC's 1-year forward projections for core inflation has been 0.37 ppts, which amounts to 21% of average core inflation rate and 100% of the standard deviation of core inflation over the projection period.</span><br />
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<span style="font-size: large;">I conducted another test to compare the accuracy of the BoC's projections with those of a naive forecasting approach. The naive approach was to assume that total CPI inflation would revert to its rolling 10-year average over the 1-year projection period. The 10-year average of the total inflation rate has been falling consistently, from 2.1% in the second quarter of 2012 to 1.6% in 2Q17. A naive forecast that total inflation in one year's time would be equal to its latest 10-year average would have produced an average absolute error or just 0.28 ppts, less than half of the error of the Bank of Canada's projections.</span><br />
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<span style="font-size: large;">You can be your own judge of these results, but from my perspective, the BoC's inflation projections since 2010 have shed virtually no light on where inflation was heading. A methodology that results in a projection error equal to 90-100% of the standard deviation of the indicator being projected is not of much value. It is a poor guide to setting monetary policy.</span><br />
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<span style="color: #b45f06; font-size: large;">Implications and Conclusions</span></h3>
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<span style="font-size: large;">The Bank of Canada is apparently not the only central bank that can't forecast inflation accurately. Brad DeLong, Professor of Economics at the University of California at Berkeley, <a href="https://www.project-syndicate.org/commentary/fed-low-inflation-more-stimulus-by-j--bradford-delong-2017-06" target="_blank"><span style="color: #b45f06;">recently took the US Fed to task for it's inflation forecasts</span></a>.</span><br />
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<span style="font-size: large;">In terms of inflationary pressure, the Fed’s forecast seems to have significantly overstated the strength of the US economy.... The FOMC’s blind spot stems from the fact that it is relying more on its assessment of the labor market, which it considers to be at or above “full employment,” than on noisy month-to-month inflation data. But “full employment” is a rather tenuous and unreliable construct....</span></blockquote>
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<span style="font-size: large;">The Fed clearly needs to take a deep look at its forecasting methodology and policymaking processes. It should ask if the current system is creating irresistible incentives for Fed technocrats to highball their inflation forecasts. And it should ensure that its policymakers view the 2% target for annual inflation as a goal to aspire to, rather than a ceiling to avoid.</span></blockquote>
<span style="font-size: large;">Another, less academic but perhaps more insightful, assessment <a href="http://www.barrons.com/articles/is-the-federal-reserve-living-in-the-real-world-1497674080?mod=BOL_columnist_latest_col_art" target="_blank"><span style="color: #b45f06;">comes from the excellent Randall Forsyth</span></a>, Associate Editor of <i>Barrons</i> and author of the weekly "Up and Down Wall Street" column:</span><br />
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<span style="font-size: large;">There seem to be two parallel universes—one described by theory, the other by reality. Most of us occupy the latter, while the former is the province of academics and policy makers.</span></blockquote>
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<span style="font-size: large;">In the theoretical world, low unemployment threatens to unleash a torrent of inflation, which needs to be staved off by tighter monetary policies. Back in the real world, disruption, innovation, and competition relentlessly drive down prices while wage growth is hard to come by.</span></blockquote>
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<span style="font-size: large;">My own conclusion is that the Bank of Canada's projections of inflation are likely to be less accurate than the rolling 10-year average, which currently sits at 1.6%, below the BoC's inflation target. The recent musings of BoC Governor Poloz that signs of improvement in Canadian economic activity might merit the removal of some monetary stimulus represent a highly speculative view based on projections from output gap models that have not performed as well as naive rules. This implies that, for the Governor's view to be justified, either the BoC's forecasting record must suddenly improve or that the BoC must be more concerned about the potential risks to financial stability created by the </span><span style="font-size: large;">extraordinarily low policy rate required for </span><span style="font-size: large;">sustained pursuit of the BoC's 2% inflation target.</span><br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-64107900113671467332017-04-23T04:32:00.003-07:002017-04-23T04:32:35.449-07:00Toronto House Price Boom: How Will It End?<span style="font-size: large;">Last year it was Vancouver house prices. This year it is the Toronto housing "crisis" that has politicians panicking. In March, the average Toronto house price was up 33% over a year ago. This news sparked a meeting of "three wise men" -- Canada's Finance Minister Bill Morneau, Ontario's Finance Minister Charles Sousa, and Toronto's Mayor John Tory -- to collaborate on appropriate actions to ease the panic. </span><br />
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<span style="font-size: large;">The three wise men agreed that they should refrain from adopting policies which would add to already overheated demand. Then within days, Ontario's Liberal government announced a "suite" of measures to respond to what they claimed was a public clamour for government intervention. Premier Kathleen Wynne and Mr. Sousa, not wanting to let a good crisis go to waste, seized the opportunity to impose a new 15% tax on non-resident buyers and tighten housing regulation in the worst possible way by imposing strict rent controls. Unfortunately, such actions that are more likely to worsen rather than improve the fundamental problem of insufficient supply of reasonably priced housing. </span><br />
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<span style="font-size: large;">I am returning to the issue of housing prices after writing about it in March, 2014 in <a href="http://tcglobalmacro.blogspot.ca/2014/03/why-so-paranoid-about-canadas-housing.html" target="_blank"><span style="color: #b45f06;">Why So Paranoid About Canada's Housing Market</span></a>, and again in June 2016 in <a href="http://tcglobalmacro.blogspot.ca/2016/06/china-stimulus-and-vancouver-house.html" target="_blank"><span style="color: #b45f06;">China Stimulus and Vancouver House Prices</span></a>. </span><br />
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<span style="font-size: large;">In March 2014, I argued that, while some high profile commentators thought Canada was in the midst of a housing bubble that was on the verge of bursting, my research showed that Canada's housing prices were still good value relative to house prices in other countries and that there was no reason to think that a Canadian house price bubble was about to burst. Looking back, that view proved correct. Far from bursting, house prices in Vancouver, in Toronto and in several other Ontario cities have since soared a further 50% or more.</span><br />
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<span style="font-size: large;">In June 2016, after Vancouver house prices had shot up over 50% in just three years, I acknowledged that they had entered bubble territory. I pointed to the effect of spillovers from China's aggressive easing of monetary policy on house prices in cities in China and also in cities such as Vancouver and Toronto that are attractive to Chinese investors. I argued, "It is the job of Finance Minister Morneau, along with provincial and city officials, to decide what measures might curb the influence of foreign central bank stimulus on Vancouver and Toronto house prices and how these measures might be applied without bringing about [a] sharp house price correction". In July 2016, Vancouver introduced a 15% Foreign Buyer Tax. In November, the city followed up with a 1% annual tax on the assessed value of vacant houses. Vancouver home sales fell immediately following the introduction of the Foreign Home Buyers tax and prices experienced a moderate setback for a six months before starting to climb again recently.</span><br />
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<span style="color: #b45f06; font-size: large;">Toronto's House Price Booms Sometimes End Badly</span></h3>
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<span style="font-size: large;">To read the local newspapers, you would think that Toronto house prices have never boomed before. There are widespread complaints that available housing data are insufficient to determine the causes of the recent rapid price appreciation. But it's not hard to find data that shows that Toronto has been here before. The chart below shows several measures of Toronto house prices dating back to 1969.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHf9EScB7g2PWEyx5iqcroLYIZ48kRlpG33G6OIHfancdaGJfp6AXNjGobRyghcIi9HmIqGHk1aAGwZgegqVpTa4meEzopXo2HmeoCGu-MuwOsQDrEecMrqEiCxsHAFl3k3QFYKobPVec/s1600/Tornonto+House+Prices.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="332" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHf9EScB7g2PWEyx5iqcroLYIZ48kRlpG33G6OIHfancdaGJfp6AXNjGobRyghcIi9HmIqGHk1aAGwZgegqVpTa4meEzopXo2HmeoCGu-MuwOsQDrEecMrqEiCxsHAFl3k3QFYKobPVec/s640/Tornonto+House+Prices.png" width="640" /></span></a></div>
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<span style="font-size: large;">The data goes back furthest for the Toronto Real Estate Board average house price (TREB AHP). Also shown are Statistics Canada's Toronto New House Price Index (NHPI) and, more recently, the Multiple Listing Service Toronto House Price Index (MLS HPI) and the Teranet Toronto House Price Index. While the quality of some of these measures is better than others, all of them tell basically the same story. There have been three house price booms in the past five decades in which annual increases reached double digits for consecutive years and peaked at 30% or more.</span><br />
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<span style="font-size: large;">The first episode, in 1974-75, saw average house prices rise 25% and 30% in consecutive years. In the second episode, in 1986-89, prices rose consecutively by 27%, 36%, 21% and 19%. In the current boom, 2015-17, average prices are on track to rise 15%, 20% and over 30% consecutively.</span><br />
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<span style="font-size: large;">After the 1974-75 boom, price increases slowed sharply. After the much bigger 1986-89 boom, prices collapsed. The chart below uses the same data as above, but expresses it as drawdowns in prices from their previous peak.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhAWqfuVLy8uuPYWnwL2zaVweeuejxvJfJodEsAQNvPIZAwS7QbhK6TEBiSgNhy9OqqBhKO6nUVfALPVW_L44wrDrnuRIMIZZdPm5wmepTpBmnRbjYpBfaSGJCWI_PCxVof6rcizQDHR2w/s1600/Toronto+House+Price+Drawdowns.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhAWqfuVLy8uuPYWnwL2zaVweeuejxvJfJodEsAQNvPIZAwS7QbhK6TEBiSgNhy9OqqBhKO6nUVfALPVW_L44wrDrnuRIMIZZdPm5wmepTpBmnRbjYpBfaSGJCWI_PCxVof6rcizQDHR2w/s640/Toronto+House+Price+Drawdowns.png" width="640" /></span></a></div>
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<span style="font-size: large;">What is clear from this chart is that the drawdown following the 1989 peak was by far the worst house price decline experienced in fifty years. Prices for both new and existing homes fell over 25% and did not hit bottom until 1996, seven years after the boom peaked.</span><br />
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<span style="color: #b45f06; font-size: large;">How Did Previous House Price Booms End?</span></h3>
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<span style="font-size: large;">In 1974-75, the boom was ended by a North American recession triggered by the first oil price shock. House prices gains slowed markedly, but there was no crash. Unfortunately, at the peak of house price and rent increases in the runup to the 1975 Ontario provincial election, Premier Bill Davis succumbed to political pressure to invoke strict rent controls. Vince Brescia, past CEO of the Federation of Rental Housing Providers of Ontario <a href="http://business.financialpost.com/fp-comment/vince-brescia-gutting-the-market-for-apartments" target="_blank"><span style="color: #b45f06;">describes the outcome</span></a>:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">The results were devastating. Rental housing supply screeched to a halt, vacancy rates quickly began to drop, rents began to rise and tenants couldn’t find apartments. Investors all pulled out of Ontario rentals; they could not operate under a system that incented owners to cut back on investment and let the buildings deteriorate.</span></blockquote>
<span style="font-size: large;">The bust in the housing market that followed the 1974-75 boom was concentrated in the collapse of rental housing construction that dragged on for over twenty years and greatly curtailed both the quality and availability of affordable housing in Toronto. </span><br />
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<span style="font-size: large;">The 1986-89 boom, the biggest Toronto house price surge of the past 50 years, was ended by a combination of rising mortgage rates, a short-lived oil price spike brought on by Iraq's invasion of Kuwait, and another North American recession. After the huge boom, prices plunged and would not recover to their 1989 peak until 2002. Toronto suffered through a lengthy house price deflation in the 1990s. </span><br />
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<span style="font-size: large;">Eventually, with the election of Conservative Premier Mike Harris on his "Common Sense Revolution" platform, rent controls ended in 1998 on buildings constructed after 1991. This move launched more than a decade of strong construction activity of both privately-owned and rental housing in Toronto that has changed the face of the city. </span><br />
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<span style="color: #b45f06; font-size: large;">How Will the Current Boom End?</span></h3>
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<span style="font-size: large;">The current Toronto house price boom is more pronounced than that of 1974-75 but less pronounced and extended than that of 1986-89. The chart below shows the three booms, with the start date set when annual house price gains exceeded 10% on a sustained basis. The horizontal axis shows the number of months from the start of the boom. The prices are in real terms (i.e. deflated by the CPI) to make them comparable.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhoBmJQW_8KgmccSFsjX-3PWOJTwSjalsho9xYsx-QQrTXSkeOLsf_kqz3gmEUL5vMf6Bsn3arv2knIVsAI0HaDjZjUjOJ6zINbAI_hIBmbkmSgbmv5uYEFDBa9xMQadBvJhzCN8_3yn5g/s1600/Toronto+Real+House+Price+Booms.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhoBmJQW_8KgmccSFsjX-3PWOJTwSjalsho9xYsx-QQrTXSkeOLsf_kqz3gmEUL5vMf6Bsn3arv2knIVsAI0HaDjZjUjOJ6zINbAI_hIBmbkmSgbmv5uYEFDBa9xMQadBvJhzCN8_3yn5g/s640/Toronto+Real+House+Price+Booms.png" width="640" /></a></div>
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<span style="font-size: large;">The chart shows that the current boom has just about matched the 1973-75 boom in duration (at 33 months vs. 36) and that cumulative real price appreciation since the start of the boom has been 55%, about 12% more than at the peak of the 1973-75 boom. However, the current boom has not yet come close to matching the 1985-89 boom in either duration or cumulative real price appreciation. </span><br />
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<span style="font-size: large;">This implies that the current boom could go on for more than another year and prices could rise by a further 30% without exceeding the 1985-89 boom. However, that may seem unlikely because governments are already taking active steps to cool the market. </span><br />
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<span style="font-size: large;">The current boom bears more similarities to 1973-75, not only in duration and magnitude, but also in the types of government action taken to cool the boom, influenced by political pressure on an Ontario Premier ahead of a provincial election.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">When the two previous booms ended real house prices fell. After the 1975 peak, real prices fell 12% over the next six years. Following the 1989 peak, real prices fell 35% over the next six years. Housing starts also went from boom to bust after the housing price peaks, as shown in the chart below. Following both the 1975 and 1989 peaks, housing starts plunged by more than 40% compared with their level at the start of the price boom.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj1nYgOoMav61MXEVE9CFGHCHfhmiKcE8yBJc1bzVCJOeJVtEALcsOo6Su_j3GMzNvsY7RY7d8UPcUfiHgGIdk57mS_kYw-Gcp1YK2pi_IooiZvOdIUHpWuHReIMEKao2et5gYfcBwLZM8/s1600/Toronto+Housing+Starts+Busts.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj1nYgOoMav61MXEVE9CFGHCHfhmiKcE8yBJc1bzVCJOeJVtEALcsOo6Su_j3GMzNvsY7RY7d8UPcUfiHgGIdk57mS_kYw-Gcp1YK2pi_IooiZvOdIUHpWuHReIMEKao2et5gYfcBwLZM8/s640/Toronto+Housing+Starts+Busts.png" width="640" /></a></div>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The current boom lies in between its' predecessors. If we are seeing the peak now, it might be reasonable to expect real prices to decline 15-20% over the next six years. However, as occurred following the 1975 peak, construction of rental housing is likely to fall dramatically and the availability of affordable housing is unlikely to grow. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Of course, if the current boom continues for another year and another 30% price appreciation, it would look more like the 1989 peak. In that event, a deep, long house price recession would become likely and future real prices might then be expected to decline something like 30-35% from the peak.</span> <br />
<br />
<span style="font-size: large;">Some may say that Toronto house prices will never decline. But they have in the past. Ben Bernanke famously <a href="http://www.businessinsider.com/bernanke-quotes-2010-12#july-2005-4" target="_blank"><span style="color: #b45f06;">said in July 2005</span></a>, "We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize." That seems to be the hope of the three wise men. But Toronto's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.</span><br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com9tag:blogger.com,1999:blog-3338983638234895144.post-89187806913768113732017-04-11T07:40:00.001-07:002017-04-11T07:40:15.704-07:00What's Happening Inside Canada's Labour Market<span style="font-size: large;">Canadian economists were quite upbeat on the March labour market report. Headlines from the major banks carried a common theme: </span><br />
<br />
<ul>
<li><span style="font-size: large;">"Canadian Jobs March On" (CIBC) </span></li>
<li><span style="font-size: large;">"The Beat Goes On" (BMO), and </span></li>
<li><span style="font-size: large;">"Canada’s job gains beat expectations again!" (RBC)</span></li>
</ul>
<span style="font-size: large;">Sounds pretty good. But even as the economists purred over the job gains, they noted that wage growth was still quite soft. The reports, as per usual, focused on the minutiae of month-to-month changes in employment across different industries and among full-time and part-time workers, many of which were not statistically significant. It's rare for economists who face the daily grind of reporting on every economic indicator to step back and look at underlying trends inside the labour market. But doing so helps explain some seeming anomalies and overall paints a less rosy picture of labour market.</span><br />
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Hours Worked Tell a Different Story</span></h3>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">While employment was up 1.5% in 1Q17 on a year-over-year basis, total hours worked by those employees at their main job was actually down 0.1% (even with a sizeable jump in hours worked in March). Main jobs are the source of the vast majority of Canadians income from work. Some, who cannot make a living wage at their main job, take on second or third jobs to supplement their incomes. Apparently, more people have had to take on extra jobs over the past year, as total hours worked at all jobs were up 1.4% in 1Q17.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">When we look at hours worked on main jobs by industry, we find that several key industries with high-paying jobs have seen substantial declines in hours worked, while other industries with low-paying jobs have seen increases in hours worked, as shown in the chart below.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZ7Lz11V4415UZofYHW0QyidxiNScSlA1GqJmom3-Dq0InqJBP0zuNEtYe0BkZHKh8CM8gqeIka3vCZAqspfwMId3bqS1GPCCmcC3twKgsf3VzX1UIhCBTGochwhhQNQtfau39jRakdKo/s1600/Avg+Hrs+Worked.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="558" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZ7Lz11V4415UZofYHW0QyidxiNScSlA1GqJmom3-Dq0InqJBP0zuNEtYe0BkZHKh8CM8gqeIka3vCZAqspfwMId3bqS1GPCCmcC3twKgsf3VzX1UIhCBTGochwhhQNQtfau39jRakdKo/s640/Avg+Hrs+Worked.png" width="640" /></span></a></div>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The biggest declines in hours worked over the past year have been in the resource sector, especially in the oil and gas industry. Manufacturing, construction and utilities have also seen substantial declines. Large employers like health and social services and education have seen small declines. At the other end of the spectrum, decent gains in hours worked have occurred in accommodation and food services, transportation and warehousing, business services (which includes waste management) and finance, insurance and real estate. By far the largest gain in hours worked over the past year has been in public services (i.e. federal, provincial and municipal governments).</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">When one sees these changes in hours worked, it becomes much less of a mystery why wage growth has been weak. According to Statistics Canada's <i>Labour Force Survey</i>, the average hourly wage earned by employees at their main job was C$26.12 in 1Q17. But some industries paid much higher (or lower) hourly wages than the average, as shown in the chart below.</span><br />
<span style="font-size: large;"><br /></span>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghvIdY20djHw5FJFoQA-DfSmc8SqxwUG7dKwWnjim46LM_ynM4omm5w0LokAISgZc3OoH0m6wlNtLKNf2NZBAp17ANN8B_vtJtx7VdUGEYeb901Kfh74TAidaIHC2qMsrPPqSHStW1vOI/s1600/Avg+Hrly+Wage+LFS.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="556" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghvIdY20djHw5FJFoQA-DfSmc8SqxwUG7dKwWnjim46LM_ynM4omm5w0LokAISgZc3OoH0m6wlNtLKNf2NZBAp17ANN8B_vtJtx7VdUGEYeb901Kfh74TAidaIHC2qMsrPPqSHStW1vOI/s640/Avg+Hrly+Wage+LFS.png" width="640" /></span></a></div>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The resource sector, which experienced the biggest decline in hours worked, was the industry with one of the highest average hourly wage rates, over $13 per hour higher than the Canadian average. The utilities, construction, and education industries, which also pay above average wages all saw declines in hours worked. In contrast, the accommodation and food services industry, which pays the lowest average hourly wage -- $11/hr below the national average and $24/hr less than the resource sector -- was one of the industries which saw a meaningful gain in hours worked. The wholesale and retail trade, transportation and warehousing, and business services sectors, which pay below average wages, also saw increases in hours worked. The one anomaly is the public sector, where hourly wages are high and hours worked posted the largest increase of any sector.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">It seems clear that Canada is experiencing decent total job growth, but that total hours worked for employee's main jobs have been flat, with high-wage industries reducing hours worked, low-wage industries increasing hours worked. This is not a sign of a healthy labour market.</span><br />
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Why is this happening?</span></h3>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">If I had to come up with a story to explain the labour market developments of the past year, it would go like this. The collapse in the world price of oil, which began in mid-2014, resulted in a dramatic declines in hours worked in Canada's resource sector in 2015 and 2016. Declines in energy-related activities spilled over into the non-residential construction, utilities and manufacturing industries. These declines were probably magnified by a tightening of environmental regulations which stalled pipeline construction and carbon tax proposals by governments concerned with global warming. With weakness in key sectors of the economy and new left-of-centre governments in Ottawa and some provinces, hours worked in governments shot up. The sharp weakening in Canada's former industrial growth drivers triggered two 25 basis point policy rate cuts in 2015 and a 20% depreciation of the Canadian dollar relative to the USD. With interest rates falling to rock-bottom levels and the currency cheapening, housing prices in Canada's most cosmopolitan cities -- Vancouver and Toronto -- became extremely attractive to both foreign and domestic purchasers and the real estate industry boomed as the house price bubble inflated. The weakening of the currency made foreign travel more expensive for Canadians, while at the same time making travel to Canada less expensive for foreigners, benefitting the transportation, accommodation and food service industries. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">So, while many economists look at Canada's job gains over the past year through rose-coloured glasses, I see the changes occurring in Canada's labour market as signs of weakness in the the Canadian economy. More Canadians are forced to work multiple jobs to make a decent living. High-paying jobs are harder to find. Employment gains are concentrated not in a thriving private sector, but in low paying industries benefitting from a cheap currency, in a bubbly and unsustainable real estate sector, and in activist, meddlesome governments. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-22700712494796916292017-04-03T05:59:00.001-07:002017-04-03T05:59:16.010-07:00Trump Trade Evolves: Global ETFs Portfolios for Canadian Investors<span style="font-size: large;">The first quarter of 2017 is in the books, so it's time to review the performance of our global ETF portfolios. The quarter kicked off with the inauguration of President Trump and ended with the Trump Administration's failure to win passage of a bill to repeal and replace Obamacare in the House of Representatives dominated by his Republican Party. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Against this background, a Canadian stay-at-home investor who invested 60% of her funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 1Q17 total return (including reinvested dividend and interest payments) of 1.7% in Canadian dollars. Had that investor diversified her portfolio to the global ETFs that are tracked in this blog, her returns would have been as much as twice that high. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The weaker performance of the all-Canadian portfolio continues a trend that began with the election of Donald Trump as US President. However, the leading global ETF performers evolved in interesting ways in 1Q17 that reflected, in part, the markets' changing assessment of Trump's ability to implement his election promises. </span><br />
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 1Q17</span></h3>
<br />
<span style="font-size: large;">The chart below shows 1Q17 returns, including reinvested dividends, in Canadian dollars (CAD), for the ETFs tracked in this blog. The returns are shown for the period from the US election in November through the end of 2016 (blue bars) and for 1Q17 (green bars). As the CAD appreciated 1.1% against USD, two of the best global ETF performers were Emerging Market equities (EEM) and Gold (GLD), each of which suffered big losses in the immediate aftermath of Trump's win. The worst performer in 1Q17 was the Commodities ETF, which had posted sharp gains immediately following the election. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhBwsy_gNAQsz-sQGlo3fsTE_RHkjHVGDvaaJ6Ndz7Pgn1MazXYJZaC9ihzhkYsxjYRD4uFpNSxcc_YAPrWpwVWo1i44y1b_wGf31qN92z4X95MRE1K704SYWJNQ-Zn_C-hS_G9Bhn5SyY/s1600/Global+ETF+Returns+1Q17.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="382" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhBwsy_gNAQsz-sQGlo3fsTE_RHkjHVGDvaaJ6Ndz7Pgn1MazXYJZaC9ihzhkYsxjYRD4uFpNSxcc_YAPrWpwVWo1i44y1b_wGf31qN92z4X95MRE1K704SYWJNQ-Zn_C-hS_G9Bhn5SyY/s640/Global+ETF+Returns+1Q17.png" width="640" /></span></a></div>
<span style="font-size: large;"><br /></span>
<br />
<span style="font-size: large;">Global ETF returns were mostly positive across the different asset classes in 1Q17. In CAD terms, 17 of 19 ETFs posted gains, while just 2 posted losses. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The best gains were in the the Emerging Market Equity ETF (EEM) which returned a strong 11.3%. The Eurozone Equity ETF (FEZ) was second best, returning 7.7% in CAD terms, followed by the Gold ETF (GLD), which returned 7.1% in CAD. Other solid gainers included the S&P500 ETF (SPY), the Japan Equity ETF (EWJ), and Emerging Market Local Currency Bonds. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The worst performers were the Commodities ETF (GSG) which returned -6.5% and the Canadian Real Return Bond ETF (XRB) which returned -1.6%.</span><br />
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance for 1Q17</span></h3>
<br />
<span style="font-size: large;">In 1Q17, the global ETF portfolios tracked in this blog posted solid returns in CAD terms. However, as with the performance of individual ETFs noted above, the performance of of the various portfolios evolved significantly in 1Q17 versus that of the immediate post election period, as shown in the chart below.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir1SuyLNVoCd7nw5bya7P5n-AclHgi62GDGr1o2HCjB0sPVyTrsXCE_l5GOwOx2-8BoWedpknQHu2TqChBllrlOtO536nANoltp2nqqFnhHliIHtb3LU9DlzyTZF5oFZvdb8K4bGvffXM/s1600/Global+ETF+Portfolio+Returns+1Q17.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="388" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir1SuyLNVoCd7nw5bya7P5n-AclHgi62GDGr1o2HCjB0sPVyTrsXCE_l5GOwOx2-8BoWedpknQHu2TqChBllrlOtO536nANoltp2nqqFnhHliIHtb3LU9DlzyTZF5oFZvdb8K4bGvffXM/s640/Global+ETF+Portfolio+Returns+1Q17.png" width="640" /></span></a></div>
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<span style="font-size: large;"><br /></span>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">A simple Canada only 60% equity/40% Bond Portfolio returned 1.7%, as mentioned at the top of this post. While solid, the 1Q17 return was weaker than the all-Canada portfolio achieved in the period immediately following the US election and also weaker than the returns on the global ETF portfolios.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 3.6% in CAD terms, continuing its strong performance in late 2016 and making it the best performing portfolio since the election. 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, returned 2.8% in 1Q17, about the same gain it enjoyed in the immediate post election period.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 2.8% in CAD terms. This was a remarkable improvement over the return of -0.17% in the immediate post election period, as bonds and foreign currencies performed significantly better in 1Q17. 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, returned 2.5%, also a significant improvement over the immediate post election period.</span><br />
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Key Events of 1Q17</span></h3>
<br />
<span style="font-size: large;">In my view, the main events that left a mark on Canadian portfolio returns in 1Q17 were President Trump's setbacks and delays in implementing his election promises; the decision by the US Fed hike its policy rate more quickly than markets had expected; and stronger-than-expected growth of DM economies outside the US. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Trump's setback on Obamacare, as well as the successful court challenges to his executive order temporarily banning immigration from certain countries, demonstrated both legislative and judicial obstacles to implementation of some of his election promises. Markets had cheered his promises to reduce regulation and cut taxes. He has made headway on cutting regulation but the setback on Obamacare has raised doubts about his ability to get controversial elements of tax reform through Congress. In addition, Trump has not yet followed through on his protectionist election promises targeting Mexico and China which had hammered Emerging Market stocks and currencies in the immediate aftermath of the election. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The Fed's decision to hike in March dampened bond prices, especially for longer term bonds. Meanwhile, stronger-than expected growth in the Eurozone, Japan and Canada helped boost equity returns outside the US. </span><br />
<br />
<h3>
<span style="color: #b45f06; font-size: large;">Looking Ahead</span></h3>
<br />
<span style="font-size: large;">At the beginning of 2017, I said that the most interesting question, in my mind, was whether the all-Canada 60/40 ETF portfolio would outperform the unhedged global ETF portfolios as it did in 2016. The answer, so far, is that since the election of Donald Trump the all-Canadian portfolio has returned to the pattern of the past five years, in which it lagged the performance of the global ETFs portfolios by a wide margin.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Three months ago, I said that answer to the question would be determined in part by the behaviour of commodity prices, the Bank of Canada and the Canadian dollar. Commodity prices which were expected to firm modestly, have fallen. The Bank of Canada has so far remained in no hurry to begin raising its' policy rate, even as the Fed hiked in March, sooner than expected. Despite weakness in commodity prices and a dovish BoC, the Canadian dollar, which was expected to weaken moderately against the USD, actually appreciated by over 1%. Upward revisions to expectations for Canadian GDP growth along with President Trump's limited success, so far, in implementing his policy promises has weighed on US dollar sentiment and helped lift the Canadian dollar. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">If Trump's plans continue to be thwarted or watered down by Congress, the trends of 1Q17 may be expected to continue. Emerging market equities, bonds, and currencies, which sold off in the immediate post-election period on fears of Trump's promises of protectionist policies, have further room to rally. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The main risk to that outlook is that President Trump, stung by his early setbacks, redoubles his efforts on protectionist trade policies and tax reform, including some form of border tax.</span> TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-26377682924273891142017-01-13T20:57:00.000-08:002017-01-13T20:57:11.299-08:00Canadian Horror Story: Trump's Border Tax<blockquote class="tr_bq">
<span style="color: #b45f06; font-size: large;"><a href="https://twitter.com/realDonaldTrump/status/817071792711942145?ref_src=twsrc%5Etfw" target="_blank">Toyota Motor said will build a new plant in Baja, Mexico, to build Corolla cars for U.S. NO WAY! Build plant in U.S. or pay big border tax. (@realDonaldTrump)</a></span></blockquote>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">With this tweet on January 5, President-elect Donald Trump got the attention of not only of Toyota and Mexico, but also a few astute Canadians. The realization began to dawn on them that Trump's promise to "Rip up NAFTA" was not the only threat to jobs and investment in Canada. Some may have even realized that the "big border tax", if adopted, could turn out to be a bigger concern than a renegotiation of NAFTA, which the Trudeau government was already contemplating.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">One of these astute Canadians, Daniel Schwanen, international trade specialist and Vice-President of Research at the C.D. Howe Institute, <a href="http://www.theglobeandmail.com/report-on-business/economy/canada-wont-escape-trumps-protectionist-measures/article33571210/" target="_blank"><span style="color: #b45f06;">when questioned about the border tax by the <i>Globe and Mail</i></span></a>, said: </span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">On its face, this proposal is devastating. This could really hurt trade and millions of workers in Canada.</span></blockquote>
<span style="font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">How Did Trump Dream Up the Border Tax?</span></h3>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The so-called border tax is not a trade policy. It is a part of a sweeping corporate tax reform that did not originate with Donald Trump, but with Paul Ryan, the Republican Speaker of the US House of Representatives and Kevin Brady, Chair of the House Ways and Means Committee, as unveiled in their “A Better Way” plan last June. As pointed out by <a href="http://www.vox.com/2016/12/25/14069822/corporate-tax-border-adjustability" target="_blank"><span style="color: #b45f06;">Dylan Mathews on Vox.com</span></a>, the Ryan-Brady plan, </span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">includes a big cut in the tax rate, from 35 percent to 20 percent. But it also includes some huge changes in the way the corporate tax works... They want to make it impossible for companies to deduct interest payments on loans... They want to make big capital investments totally deductible in the year they’re made rather than “depreciable” over time... <i>But perhaps most dramatically of all, they want to allow companies to totally exclude revenue from exports when calculating their tax burden, and to ban them from deducting the cost of imports they purchase.</i> </span></blockquote>
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Think of how this change would affect US companies that purchase imported goods from Canada (or elsewhere) either as inputs to their own production or for final sales to US consumers. Currently, such imports are a deductible business expense when calculating US corporate taxes. Under the Ryan-Brady plan, the cost of imported goods would not be deductible. The cost of inputs purchased from US domestic companies would be deductible from US corporate tax, providing a huge cost advantage to sourcing inputs from within the United States rather than from abroad. On balance, the result of the corporate tax reform would be equivalent to imposing a 20% tariff on imports from Canada (and other countries). </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">Now think of how the change would affect US companies that export to Canada where they compete with Canadian companies. The US companies would no longer have to pay any corporate tax on their export revenues. As a result, US companies would either see a large increase in their profit margins on exports or they could cut their prices, thereby forcing Canadian companies to do the same. But Canadian companies would still have to pay Canadian corporate taxes on their revenues.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">This would be a horror story for Canada (and Mexico and other major US trading partners). The table below shows Canada's exports to and imports from the United States.</span><br />
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<span style="font-size: large;">Based on 2015 data, the latest year available, the border tax would be assessed on C$367 billion of Canadian exports to the US. Canada's export-oriented industries </span><span style="font-size: large;">–</span><span style="font-size: large;"> energy, motor vehicles and parts, minerals and metals, and forest products </span><span style="font-size: large;">–</span><span style="font-size: large;"> would be placed at a big competitive disadvantage relative to US-based competitors. At the same time, </span><span style="font-size: large;">C$285 billion of US exports to Canada would not be subject to US corporate tax. </span><span style="font-size: large;">Canada’s import competing industries – food products, machinery and equipment and other consumer goods – would face much stiffer competition from US exporters that would not have to pay corporate tax.</span><br />
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<span style="color: #b45f06; font-size: large;">How US Economists View the Border Tax</span></h3>
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<span style="font-size: large;">Such sweeping US tax changes may seem radical, but they have support from respectable US economists including Alan Auerback of Berkeley, who has long been <a href="https://www.americanactionforum.org/wp-content/uploads/2016/11/The-Role-of-Border-Adjustments-in-International-Taxation.pdf" target="_blank"><span style="color: #b45f06;">a proponent of the border tax</span></a>, and Martin Feldstein of Harvard, who wrote in an <a href="http://www.nber.org/feldstein/wsj01052017.html" target="_blank"><span style="color: #b45f06;">op-ed piece endorsing the idea in the Wall Street Journal</span></a> on January 5, the same day Trump tweeted about the border tax.</span><br />
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<span style="font-size: large;">Feldstein explains the new border tax with some simple examples. Here is one, with my additions to make the consequences clear for Canada shown in brackets:</span><br />
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<span style="font-size: large;">A U.S. importer that pays $100 to import a product [from Canada] can, if there is no border tax adjustment, sell that product to a U.S. retail customer for $100. But with the border tax adjustment, the $100 import cost is not deductible from the corporate tax base. The price to the U.S. retail buyer would have to be $125, of which $25 would go toward the 20% tax... This calculation makes it look as if the border tax adjustment causes the U.S. consumer to pay 25% more for [imports from Canada]. But the price changes that I have described would never happen in practice because the [US] dollar's international value would automatically rise by enough to eliminate the increased cost of imports... With a 20% corporate tax rate, that means that the value of the [US] dollar must rise by 25%. [This means that the US dollar would have to rise to 1.67 Canadian dollars from 1.33 currently, meaning that the Canadian dollar would need to drop to 60 US cents]. The rise of the dollar relative to foreign currencies means that the real purchasing power of foreigners declines to the extent that they import products from the United States or sell products to the U.S.</span></blockquote>
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<span style="font-size: large;">Feldstein explained his view that the US dollar would strengthen quickly to offset the impact of higher import prices for US consumers at this link on <a href="https://www.bloomberg.com/news/videos/2017-01-12/martin-feldstein-explains-border-tax-adjustment-effects" target="_blank">Bloomberg TV</a>. You can judge for yourself whether you believe exchange rates would move as Marty asserts. He also asserted that the border tax would raise US$120 billion per year relative to the current corporate tax with the tax burden being borne by US trade partners. </span><br />
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<span style="font-size: large;">Not all US economists support the border tax idea. Lawrence Summers, former Treasury Secretary in the Clinton Administration and therefore not likely to have may sway with Trump, wrote this in <a href="https://www.washingtonpost.com/opinions/trump-and-ryan-are-right-to-tackle-corporate-taxes-but-their-approach-would-do-harm/2017/01/08/e7abd204-d429-11e6-9cb0-54ab630851e8_story.html?utm_term=.01ad3e311c45" target="_blank"><span style="color: #b45f06;">an op-ed in the Washington Post on January 9</span></a>:</span><br />
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<span style="font-size: large;">[T]he tax change would likely harm the global economy in ways that reverberate back to the United States. It would be seen by other countries and the World Trade Organization as a protectionist act that violates U.S. treaty obligations. While proponents argue that such an approach should be legal because it would be like a value-added tax, the WTO has been clear that income taxes cannot discriminate to favor exports. While the WTO process would grind on, protectionist responses by others would be licensed immediately. Moreover, proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 percent tax rate. This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets. Because U.S. foreign assets are mostly held in foreign currencies whereas debts are largely in dollars, U.S. losses with even a partial appreciation would be in the trillions.</span></blockquote>
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<span style="color: #b45f06; font-size: large;">What Could Canada Do?</span></h3>
<span style="font-size: large;">Trump's apparent adoption of the border tax as a tailor-made solution to his election promises to Make America Great Again and to bring back manufacturing jobs to the United States should be the top concern for Canada's new Foreign Affairs Minister Chrystia Freeland and for Finance Minister Bill Morneau. Prime Minister Justin Trudeau, who is busy right now engaging with ordinary Canadians in coffee shops across the country, needs to be briefed.</span><br />
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<span style="font-size: large;">It is less clear what Canada could do about it, if President Trump and the Republican Congress get on board with the border tax. During the Nixon Administration, when the US slapped on a (short-lived) 10% import surcharge, the Pierre Trudeau government sent its envoys to Washington to seek an exemption, but none was given. Obtaining an exemption from a US corporate tax reform would be a tall order even for a government on good terms with the US Administration. Presumably, Canada would need to adopt a similar corporate tax framework to that of the US and seek to have Canadian produced goods treated the same as US produced goods for corporate tax purposes in both countries. That would take a lot of doing.</span><br />
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<span style="font-size: large;">Another alternative would be to join together with other US trade partners and challenge the border tax at the World Trade Organization. As Larry Summers points out, while the WTO process grinds on, disruption of trade with the US would be severe and retaliation by some US trade partners would be likely.</span><br />
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<span style="font-size: large;">A final alternative would be to grin and bear it and accede to Marty Feldstein's solution of letting the Canadian dollar weaken about 20% further against the US dollar to keep our exports from getting priced out of the US market. This would mean a further large hit to Canadian's purchasing power and tacit agreement by Canadians to bear part the cost of reducing the US fiscal deficit.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-60073012413132922122017-01-09T07:47:00.000-08:002017-01-09T07:47:47.573-08:00Global ETF Portfolios: 2016 Returns for Canadian Investors<span style="font-size: large;">Last year I started my annual review of portfolio returns by saying; “2015 was a lousy year for Canadian investors”. Well, 2016 was a turnaround year as the Canadian dollar strengthened modestly and Canadian equities rebounded strongly.</span><br />
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<span style="font-size: large;">A stay-at-home 60/40 investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 2016 total return (including reinvested dividend and interest payments) of 13.9% in Canadian dollars, a dramatic improvement from the 3.1% loss generated by the same portfolio in 2015. The Canadian dollar strengthened 2.8% against the US dollar, so the all Canadian 60/40 Portfolio had a 2016 total return of 17.2% in US dollar terms, a substantial recovery from the 19% loss in USD terms in 2015.</span><br />
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<span style="font-size: large;">The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavor, we track various portfolios made up of different combinations of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios. </span><br />
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<span style="font-size: large;">Since we began monitoring these portfolios at the end of 2011, we have found that the Global ETF portfolios have all vastly outperformed a simple stay-at-home portfolio. In 2016, we saw a reversal of this trend.</span><br />
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<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 2016</span></h3>
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<span style="font-size: large;">In 2016, with the CAD appreciating almost 3% against USD and 8% against EUR, the best global ETF returns for Canadian investors were in Canadian equities and US small cap equities. The worst returns were in Eurozone bonds and equities and US Treasury bonds. The chart below shows 2016 returns, including reinvested dividends, in CAD terms, for the ETFs tracked in this blog. The returns are shown for the full year (green bars) and for the period following the election of Donald Trump as President in October (blue bars).</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi17HLaGEcbavGDU0HV4DiH8RutPhLoqudge592FEeGD9-a9-HSvAxa1mGvzMnbvFhanIQZobC5W45t3-9F0dcs-PkPSkRU_L7ywkpueYCNIlQ7jRqA_g9HJJGG4wPqfIp-p1JfwO_hKAs/s1600/Global+ETF+Returns+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="402" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi17HLaGEcbavGDU0HV4DiH8RutPhLoqudge592FEeGD9-a9-HSvAxa1mGvzMnbvFhanIQZobC5W45t3-9F0dcs-PkPSkRU_L7ywkpueYCNIlQ7jRqA_g9HJJGG4wPqfIp-p1JfwO_hKAs/s640/Global+ETF+Returns+2016.png" width="640" /></a></div>
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<span style="font-size: large;">Global ETF returns varied widely across the different asset classes in 2016. In CAD terms, 15 of 19 ETFs posted gains, while just 4 posted losses. </span><br />
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<span style="font-size: large;">The best gains were in the Canadian equity ETF (XIU) which returned a robust 21.2%. The US Small Cap Equity ETF (IWM) was second best, returning 18.2% in CAD terms, followed by the US High Yield Bond ETF (HYG), which returned 10.3% in CAD. Other decent gainers included the S&P500 ETF (SPY), the Emerging Market Equity ETF (EEM), the commodity ETF (GSG), and Emerging Market Bonds, both USD-denominated (EMB) and local currency denominated (EMLC). </span><br />
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<span style="font-size: large;">The worst performers were the Non-US Government Bond ETF (BWX), the Long-term (10-20yr) US Treasury Bond (TLH), Eurozone Equities (FEZ), and Japanese Equities (EWJ).</span><br />
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<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance for 2016</span><br />
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<span style="font-size: large;">In 2016, the global ETF portfolios tracked in this blog posted decent returns in CAD terms when USD currency exposure was left unhedged and stronger returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWS2o9O2SGUs9Rihe36NG11arpNKuwzLDrCDVYyfx8ZBtUYcOS276O-rNhi4DNhSO5g0q2MHvuAMk-jgiQakbJMY4AX7ELlzz2M8KYymbrfw6DUlc_B8COWYs6WhIK99a8n1PbzLACJYk/s1600/ETF+Portfolio+Returns+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="360" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWS2o9O2SGUs9Rihe36NG11arpNKuwzLDrCDVYyfx8ZBtUYcOS276O-rNhi4DNhSO5g0q2MHvuAMk-jgiQakbJMY4AX7ELlzz2M8KYymbrfw6DUlc_B8COWYs6WhIK99a8n1PbzLACJYk/s640/ETF+Portfolio+Returns+2016.png" width="640" /></a></div>
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<span style="font-size: large;">A simple Canada only 60% equity/40% Bond Portfolio returned 13.9%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 6.0% in CAD terms when USD exposure was left unhedged, but 7.7% 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 7.4% if unhedged, and 8.8% if USD hedged.</span><br />
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<span style="font-size: large;">Risk balanced portfolios performed similarly in 2016 if unhedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a 6.1% in CAD terms if USD-unhedged, but had a strong return of 10.9% 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, returned 7.4% if USD-unhedged, but 9.8% if USD-hedged.</span><br />
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<span style="color: #b45f06; font-size: large;">Four Key Events of 2016</span><br />
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<span style="font-size: large;">In my view, there were four key policy events that left a mark on Canadian portfolio returns in 2016. The first was the Bank of Canada's decision not to cut the policy rate in January. The second was the US Fed's decision to delay its decision to hike the US policy rate until December. The third was the Brexit vote. The fourth was the unexpected election of Donald Trump. </span><span style="font-size: large;">The impact of each of these four events can be seen in the chart below which tracks weekly portfolio returns over the course of 2016. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGsZf4mubKkLTZ9l1t1JX5-dw6bWntWbWIoV5OtJI5HySkXuI6Dz5osztW3QgjUqP3MpmvD1vsbjbuTFKyDvvL16eg8BkA84lI9sNhtv06A0RGy7_aPbRt2CVijBYcqkXENhLM-GnvWeI/s1600/Weekly+Portfolio+Returns+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="336" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGsZf4mubKkLTZ9l1t1JX5-dw6bWntWbWIoV5OtJI5HySkXuI6Dz5osztW3QgjUqP3MpmvD1vsbjbuTFKyDvvL16eg8BkA84lI9sNhtv06A0RGy7_aPbRt2CVijBYcqkXENhLM-GnvWeI/s640/Weekly+Portfolio+Returns+2016.png" width="640" /></a></div>
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<span style="font-size: large;">The Bank of Canada's decision not to validate market expectations which leaned toward a January rate cut, provided a boost for the Canadian dollar but weakened returns on unhedged global portfolios. The Fed’s decision to delay hiking the US policy rate in response to weak first half real GDP growth kept the Canadian dollar on a strengthening path until mid-May, when the Fort McMurray forest fires caused a stumble in Canadian growth and a weakening of CAD. The Brexit vote on June 23 triggered a brief pullback in global equity markets and, combined with the introduction of negative policy rates in the Eurozone and Japan, saw global bond yields fall to their low for the year. This combination saw a period of outperformance by risk balanced portfolios with heavier allocations to fixed income. </span><br />
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<span style="font-size: large;">The US election (along with a strengthening in global economic data) triggered a US-led rally in equity markets. US equity ETFs, especially the Small Cap ETF (IWM), performed best after the election, along with the commodity ETF. The US dollar gained ground against all currencies, including the Canadian dollar. Bonds sold off sharply everywhere. As a result, equity-heavy (and bond-light) portfolios performed best in the post-election period.</span><br />
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<span style="font-size: large;"><span style="color: #b45f06;">Looking Ahead (Through the Fog) </span></span></h3>
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<span style="font-size: large;">As we enter 2017, the most interesting question, in my mind, is whether the all-Canada 60/40 ETF portfolio will continue to outperform the unhedged global ETF portfolios as it did in 2016. As the chart below shows, the 2016 outperformance was the first since we started tracking these portfolios at the end of 2011. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivuZIJ6lPkwA25AMA6YQUslhIo_Uor9ubN0FY4zaffSl6TQEqJ8MqiqI-VWjaR8FFoHcKR8f1jSAo1sNoGHfryeyDk77K4uOkTYv-JuccZ4d_swLEMcxEdyvf9hWYuk2k7_LNJZ0rPy8w/s1600/Global+ETF+Portfolio+5-yr+Returns.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="346" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivuZIJ6lPkwA25AMA6YQUslhIo_Uor9ubN0FY4zaffSl6TQEqJ8MqiqI-VWjaR8FFoHcKR8f1jSAo1sNoGHfryeyDk77K4uOkTYv-JuccZ4d_swLEMcxEdyvf9hWYuk2k7_LNJZ0rPy8w/s640/Global+ETF+Portfolio+5-yr+Returns.png" width="640" /></a></div>
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<span style="font-size: large;">Even taking 2016 into account, the Canada 60/40 portfolio has returned 6.3% per annum over the past five years, badly trailing the global portfolios, which have all returned between 9.6% and 10.2% per annum. A C$100 investment in the Canada 60/40 ETF portfolio at the end of 2011 would have risen in value to C$137 by the end of 2016, compared with C$158-163 for the four global ETF portfolios we track.</span><br />
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<span style="font-size: large;">The answer to the question will be determined largely by the behaviour of commodity prices, the Bank of Canada and the Canadian dollar. Consensus expectations look for commodity prices to firm modestly, for the Bank of Canada to remain on hold even as the Fed hikes its policy rate by 75 basis points and for the Canadian dollar to weaken moderately against the USD. The consensus does not unambiguously favor either the all-Canada or the global portfolios. The best plan seems to be to wait, to watch and to react as economic and policy uncertainty gives way to more clarity.</span> <br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-8229813638192484002017-01-03T21:41:00.000-08:002017-01-03T21:41:24.932-08:002017 Economic Outlook: Consensus and Other Views<span style="font-size: large;">It's time to look ahead to global macro prospects for 2017. I have posted similar outlooks for the past three years and followed up at the end of each year with an assessment of those forecasts. I assemble consensus views for the year ahead on global growth, inflation, interest rate and exchange rate outlooks which are presumably already built into market prices. The consensus view, as Howard Marks says, is "usually unhelpful at best and wrong at worst". What will move markets in 2017 is not the current consensus forecast, but the ways in which actual economic developments diverge from that consensus.</span><br />
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<span style="font-size: large;">The big surprises of 2016 – Brexit, the impeachment of President Dilma Roussef in Brazil, and the election of Donald Trump as President – will have significant economic impacts in 2017 and beyond. </span><br />
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<span style="font-size: large;">The US equity market, as well as those of several other countries, has responded positively to Trump’s election. Investors have essentially placed bets that Trump’s early moves will focus on reducing taxes and regulations and that his campaign rhetoric about ripping up trade deals and deporting millions of illegal immigrants will proceed with caution.</span><br />
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<span style="font-size: large;">Many high profile economists – <a href="http://www.nytimes.com/2016/12/26/opinion/and-the-trade-war-came.html" target="_blank"><span style="color: #b45f06;">Krugman</span></a>, <a href="https://www.project-syndicate.org/commentary/trump-trade-war-with-china-by-stephen-s--roach-2016-12" target="_blank"><span style="color: #b45f06;">Roach</span></a>, and <a href="http://www.theglobeandmail.com/globe-investor/investment-ideas/research-reports/article33345008.ece/BINARY/Breakfast_with_Dave_Dec_2016.pdf" target="_blank"><span style="color: #b45f06;">Rosenberg</span></a> – are warning of much more pessimistic outcomes (some of these views seem quite partisan). Some warnings take Trump’s election rhetoric on trade and immigration at face value. Others are based on the notion that Congress will not actually implement many of Trump's election promises.</span><br />
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<span style="font-size: large;">Despite the market’s optimistic response and the aforementioned economists’ warnings, economic the consensus forecast has barely changed since before the US election. I do not think that means the election outcome will have little effect on economic and financial market performance in 2017 and beyond. I think it means that forecasters are a bit like deer in the headlights, not knowing yet which way to jump. The consensus remains unchanged as some forecasters shade their views in favor of the market’s optimism and others shade theirs in favor of the more pessimistic view. As I said in my review of 2016 forecasts last month, “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”.</span><br />
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<span style="font-size: large;">With the foregoing in mind, here is what the consensus view is telling us about 2017:</span><br />
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<li><span style="font-size: large;">Global real GDP growth is expected to be modestly stronger than 2016;</span></li>
<li><span style="font-size: large;">Global inflation is expected to be higher than in 2016;</span></li>
<li><span style="font-size: large;">The Fed is expected to hike the Fed Funds rate by 75 basis points, while other DM central banks are mostly expected to hold their policy rates steady and some EM central banks are expected to lower rates;</span></li>
<li><span style="font-size: large;">In the DM, 10-year government bond yields are expected to rise in the US, UK and Eurozone, but be little changed in Japan, Canada and Australia; In the EM, 10-year yields are expected to rise modestly in Brazil, Russia and Korea, but to fall in India, China and Mexico.</span></li>
<li><span style="font-size: large;">After strengthening against most of the currencies we track in 2016, the US dollar is expected to turn in a more mixed performance. Views of individual currency forecasters for 2017 exhibit much more dispersion than forecasts for other economic variables, but when averaged into a consensus view, most currencies are expected to move less than 2% against the USD. This seems like a very unlikely outcome. But for what it’s worth, the USD is expected to strengthen by the end of 2016 against RBL, BRL, CNY and CAD and to weaken against GBP, EUR, JPY, AUD, and MXN.</span></li>
<li><span style="font-size: large;">After strong performances in 2016, equity strategists tell us that US and Canadian stock markets are expected to post more modest gains of about 6% and 4%, respectively.</span></li>
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<span style="font-size: large;">This year’s growth forecasts are notably more conservative than last year’s, as economists belatedly turn more cautious after several years of growth disappointing to the downside. Inflation once again is expected to move higher but, with the exception of the Fed, central banks are not expected to respond to higher inflation by tightening policy. </span><br />
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<span style="color: #b45f06; font-size: large;">Global Real GDP Growth Forecasts</span></h3>
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<span style="font-size: large;">Last year at this time, global growth was expected by the IMF to pick up to 3.5% in 2016 from 3.1% in 2015. Economists at five large global commercial bank expected a more modest acceleration to 3.4%. Instead, global growth is now estimated to have slowed to 3.0% in 2016.</span><br />
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<span style="font-size: large;">This year, forecasters tell us once again that global growth will pick up in 2017 to 3.4% (IMF October forecast), or to 3.3% (OECD November forecast and the December average of global commercial bank forecasts).</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHD842IDtyR4_XCDOL5WJ1DNVefJL1G4U9LJceRaor8quS4g3qHmrtgCXomqZS8JEjoFHYAHFegfmIY9-sNCzpGjLUoY5pbQFoKs8rG0H6RQfqnAvV1hEyQfPX44cW0RdtqC3uabkvMc4/s1600/2017+Real+GDP+Forecasts.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="510" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHD842IDtyR4_XCDOL5WJ1DNVefJL1G4U9LJceRaor8quS4g3qHmrtgCXomqZS8JEjoFHYAHFegfmIY9-sNCzpGjLUoY5pbQFoKs8rG0H6RQfqnAvV1hEyQfPX44cW0RdtqC3uabkvMc4/s640/2017+Real+GDP+Forecasts.png" width="640" /></span></a></div>
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<span style="font-size: large;">Real GDP growth in 2017 is expected to be stronger in many economies, but with the notable exceptions of the Eurozone, UK, China, Korea and Mexico. Economies with the largest forecast growth pickups include India (7.3% in 2017 vs 6.7% in 2016), Canada (1.8% vs 1.3%), US (2.0% vs 1.6%), Japan (1.3% vs 1.0%), and Australia (2.7% vs 2.4%),. </span><br />
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<span style="font-size: large;">While global growth is expected to be stronger in 2017, an important divergence between DM and EM growth performance is expected to continue. EM growth is consistently higher than DM growth, but the important divergence is that, for a third consecutive year, DM economies (with the exception of the UK) are expected to grow at or above their trend rate of growth, while most EM economies (with the exception of India) are expected to grow below their trend rate. In the chart below, the blue bars show the 2017 consensus growth forecast versus the OECD estimate of the trend growth rate for each economy.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEinZa9zZ7xG9RnFNzPpGnrRorVpb8qnCtLQbFxMzTXxGykFcPyeYs-zRwee-v7zQcr0r8RAgFSN2C02KhzGGO6rfJJLcBefw97PkGeuAD5EGZlZ8VpfvqBmm27XcZLfuhdmCJIk_GojBbk/s1600/2017+Real+Growth+vs+Trend.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="334" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEinZa9zZ7xG9RnFNzPpGnrRorVpb8qnCtLQbFxMzTXxGykFcPyeYs-zRwee-v7zQcr0r8RAgFSN2C02KhzGGO6rfJJLcBefw97PkGeuAD5EGZlZ8VpfvqBmm27XcZLfuhdmCJIk_GojBbk/s640/2017+Real+Growth+vs+Trend.png" width="640" /></span></a></div>
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<span style="font-size: large;">In 2017 the Eurozone and Japan are expected to grow at an above trend pace, while the UK – dealing with Brexit uncertainty – is expected to grow well below trend. In contrast, four of the larger EM economies are expected to grow well below trend: Mexico (1.0% below trend), Russia (0.9% below trend), Brazil (0.7% below trend) and China (0.5% below trend). </span><br />
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<span style="font-size: large;">In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) versus trend for each of the economies. Unlike in the past two years, these CLIs generally support stronger 2017 growth than economists are forecasting, with a few exceptions.</span><br />
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<span style="font-size: large;">In the DM economies, the leading indicators suggest that growth could surprise on the strong side in the Eurozone and Canada but on the downside in the US and Japan. In the EM economies, CLIs suggest that growth could be </span><span style="font-size: large;">stronger than expected in Brazil, India, Russia and Korea but </span><span style="font-size: large;">weaker than expected in China.</span><br />
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<span style="color: #b45f06; font-size: large;">Global Inflation Forecasts</span></h3>
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<span style="font-size: large;">Global inflation has consistently fallen short of expectations since 2013. This occurred in spite of unprecedented efforts by central banks to fight disinflation.</span><br />
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<span style="font-size: large;">A year ago, global inflation for the entire set of world economies was expected by the IMF to move up to 3.5% by the end of 2016 from 2.9% at the end of 2015. By October 2015, the IMF had cut its year-end 2016 global inflation forecast to 3.2%. Meanwhile, a year ago, global commercial bank economists expected weighted average inflation for 12 major economies we track to move up to 2.3% in 4Q16 from 2.0% in 4Q15. Instead, inflation for these countries remained flat at 2.0% in 4Q16. For 2017, the Bloomberg consensus of economists forecasts that weighted average inflation for the 12 countries will rise to 2.5% in 4Q17. The IMF and the OECD expect a slightly bigger acceleration for the 12 countries to 2.6%.</span><br />
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<span style="font-size: large;">These forecasts, most of them made between mid-November and early-December, may already subject to upward revision. Crude oil prices ranged from $45 to $49 per barrel during the period these forecasts. Since then, in the wake of the December OPEC meeting, the price has risen to $54/bbl in late December and looks likely to maintain the higher price into early 2017.</span><br />
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<span style="font-size: large;">In all of the DM economies we track, inflation is expected to rise. In EM economies the picture is more mixed, with inflation expected to fall in Brazil and Russia, where currencies have strengthened markedly over the past year. In Mexico and China, where currencies have weakened, inflation is expected to rise. Considerable slack remains in the global economy, especially in EM economies. But wage growth is picking up in some countries. Commodity prices are rising. Inflation expectations are rising.</span><br />
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<span style="color: #b45f06; font-size: large;">Non-Consensus Views</span></h3>
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<span style="font-size: large;">As already mentioned, some economists, who are not part of the consensus, have a much darker view of 2016 prospects. Paul Krugman and Stephen Roach warn that Trump will set off trade wars with China, Mexico and other US trade partners. Krugman says, “Will this cause a global recession? Probably not … What the coming trade war will do is cause a lot of disruption … and quite a few American manufacturing operations would end up being big losers.”</span><br />
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<span style="font-size: large;"><a href="http://marketplace.eri-c.com/lots/russell-napiers-solid-ground-fortnightly---the-sweet-smell-of-success---14-december-2016" target="_blank"><span style="color: #b45f06;">Russell Napier</span></a> sees a different problem with the consensus: </span><br />
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<span style="font-size: large;">The consensus may be bullish on the USD exchange rate and while consensus is regularly wrong, on this occasion it might be wrong because it is not bullish enough! </span></blockquote>
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<span style="font-size: large;">Napier argues that “the USD has much, much further to rise” and that this will present a particularly difficult environment for China, which is also one of the major targets of Trump’s protectionist rhetoric. Rising US interest rates have spilled over globally and have aggravated China’s capital flight and accelerated the decline in China’s foreign exchange reserves. Napier suggests that it is “time for China to grow up and run an independent monetary policy choosing the appropriate price or supply or money without reference to the level of the exchange rate.” A strengthening USD and a depreciating CNY are “turning the deflationary screws on the global economy. It will likely be up to the Fed to stop the rise of the US dollar, but what ammunition is at its disposal, particularly if the President’s fiscal policy is indeed stoking domestic inflation?”</span><br />
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<span style="font-size: large;">David Rosenberg graciously offered up <a href="http://www.theglobeandmail.com/globe-investor/investment-ideas/research-reports/article33345008.ece/BINARY/Breakfast_with_Dave_Dec_2016.pdf" target="_blank"><span style="color: #b45f06;">a free year-end piece</span></a>, which the <i>Globe and Mail</i> ran with the headline: "Forget inflation - here's what really will happen in 2017". The headline is a bit misleading because Rosenberg, quite reasonably, says “I actually find it senseless to provide a forecast for the entire year ahead at this time”. While declining to provide a forecast, Rosenberg is pretty sure about one thing: “I do have as strong view that inflation very much is going to be the non-event it has for the past several decades”. Rosenberg provides several good reasons why Trump’s platform will be disinflationary. Although bond yields will be volatile over the course of 2017, Rosenberg thinks that </span><span style="font-size: large;">as inflation fears abate,</span><span style="font-size: large;"> </span><span style="font-size: large;">the 10-year US Treasury yield will fall and "close the year around 2%", about 70 basis points lower than the consensus forecast. </span><br />
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<span style="font-size: large;">Another non-consensus view is that of Wall Street’s number one ranked strategist, Francois Trahan, Head of Portfolio Strategy at Cornerstone Macro. In this video <a href="http://wealthtrack.com/trahan-stunning-bearish-call/" target="_blank">Trahan goes against the consensus</a> with a view that the equity bull market is almost over and it’s time to get defensive. He makes this argument partly on the assumption that Congress will not pass all of Trump’s pro-growth policies and their effect will be delayed but, more importantly, because US monetary policy is tightening, global financial conditions are tightening, and growth is about to slow significantly. He argues that macro policy forces already in the pipeline will outweigh anything Trump does in 2017 and the result will be lower US corporate earnings and a lower P/E ratio, so that the slowdown will have a disproportional impact of equity prices. Trahan expects US data to weaken in 1H17 after a burst of strength in late 2016. The result will be a significant correction and possibly a bear market in equities. I have to give Trahan credit; he has the conviction to go against the frozen Wall Street consensus. </span><br />
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<span style="font-size: large;">I'm not suggesting that we should toss out the consensus forecast; it provides a useful benchmark against which to measure the coming surprises of 2017. But, as with other non-consensus analysts, I am suggesting that once again we should apply a hefty discount rate to the consensus and consider the risks around a wide range of possible optimistic and pessimistic scenarios. </span><br />
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<span style="color: #b45f06; font-size: large;">Questions and Conclusions</span></h3>
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<span style="font-size: large;">2016 turned out to be another year in which global growth and inflation were both modestly disappointing and the political surprises were widely viewed in a negative light. Risk assets nevertheless performed very well. The legacy of the political surprises of 2016 is policy uncertainty for 2017. Some of the unanswered questions include: </span><br />
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<li><span style="font-size: large;">How will the UK and the EU handle Brexit? And will other EU countries follow the UK's lead? </span></li>
<li><span style="font-size: large;">Which of Trump’s election promises will be implemented and when? </span></li>
<li><span style="font-size: large;">How will US trading partners respond to Trump’s protectionism? </span></li>
<li><span style="font-size: large;">How will global markets react and adjust to expected Fed tightening? </span></li>
<li><span style="font-size: large;">Will the expected continued strengthening of the US dollar combined with below trend growth in China, Brazil and Russia create financial instability and continue to exert global deflationary pressures? </span></li>
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<span style="font-size: large;">At the moment, I would be quite suspicious of the advice being offered by many investment strategists. Those who have been long the growth trade and have benefited from the “Trump rally” in equity markets are suggesting stay with the trade in the near term but be flexible and prepared to exit should the recent optimism be blunted by disappointments. Those strategists who went into the US election in a defensive position and remain skeptical that Trump’s policies can “Make America Great Again” are suggesting maintaining larger than normal cash positions which may be deployed when risk assets correct sometime in 2017. </span><br />
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<span style="font-size: large;">In 2017, I’m afraid, we are on our own.</span><br />
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<i>Ted Carmichael is Founding Partner of Ted Carmichael Global Macro. Previously, he held positions as Chief Canadian Economist with JP Morgan Canada and Managing Director, Global Macro Portfolio, OMERS Capital Markets. </i><br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-78856473955918817892016-12-12T20:33:00.002-08:002016-12-15T05:54:30.835-08:00The Biggest Global Macro Misses of 2016<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;">Real GDP</span></h3>
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<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgDgWUfupxNNzgKdDYC8yXl-EqfNdOxxzsTb-BXzlyB1XYcRvfnu20VKJB1Fq0btGY84Mr-F3YpjSVPpLxKZJWrfVUCwsYqkzVyBqMBNMjUJHFULddxJbmXI4CtgpM3URON1R546C21TWk/s1600/Real+GDP+Misses+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="364" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgDgWUfupxNNzgKdDYC8yXl-EqfNdOxxzsTb-BXzlyB1XYcRvfnu20VKJB1Fq0btGY84Mr-F3YpjSVPpLxKZJWrfVUCwsYqkzVyBqMBNMjUJHFULddxJbmXI4CtgpM3URON1R546C21TWk/s640/Real+GDP+Misses+2016.png" width="640" /></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;"><b>CPI Inflation</b></span><br />
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<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGYVzIyGCwIR31gPkRYanF98XwtoPnF7bpVwwchtitnk-O5Pvi6PCNafeS7dHMvKLNswEMOBrhLxwS45U0zvMBX9B6towX-sjynmVKtC2ggFkN39N6Dv843-6izFCx74QTL6w8uDqI3co/s1600/Inflation+Misses+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGYVzIyGCwIR31gPkRYanF98XwtoPnF7bpVwwchtitnk-O5Pvi6PCNafeS7dHMvKLNswEMOBrhLxwS45U0zvMBX9B6towX-sjynmVKtC2ggFkN39N6Dv843-6izFCx74QTL6w8uDqI3co/s640/Inflation+Misses+2016.png" width="640" /></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;"><b>Policy Rates</b></span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;"><b>10-year Bond Yields</b></span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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 </span><span style="font-size: large;">pct. pt.), Eurozone (proxied by Germany, -0.49), </span><span style="font-size: large;">Japan (-0.39), and </span><span style="font-size: large;">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, </span><span style="font-size: large;">where inflation fell much more than expected and reduced political uncertainty saw </span><span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;"><b>Exchange Rates</b></span><br />
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<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSoCc-tQC3sZxmg2sX0c_wh51LPHowDEXAPyiKz3vweuO0De-dmNQEzLHkAuigaIchN5UBeUo-jzRVWFxjBgtk-P_1vBG0YJ620LXghRUCq5c4tHQUtq2KakYSw0kV8RapyrJYmB9GPTk/s1600/FX+misses+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSoCc-tQC3sZxmg2sX0c_wh51LPHowDEXAPyiKz3vweuO0De-dmNQEzLHkAuigaIchN5UBeUo-jzRVWFxjBgtk-P_1vBG0YJ620LXghRUCq5c4tHQUtq2KakYSw0kV8RapyrJYmB9GPTk/s640/FX+misses+2016.png" width="640" /></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;"><b>North American Stock Markets</b></span><br />
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<span style="font-size: large;">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 </span><span style="font-size: large;">political surprises that were widely-perceived as negative, </span><span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNpZCcdzh-a0VXHyOxRGdzS5EFyD6LKj56ucp14WmBBujX_AQy-AVm-D_N0_UiUzAi3u7MxrqaQhvn91fT7ae3MfZgfnGPGgRO-Ul5ZuhE_wxd_d7bBXSzssxD7Cu0v9k8zQBw8q4nRw0/s1600/NA+Equity+Misses+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="370" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNpZCcdzh-a0VXHyOxRGdzS5EFyD6LKj56ucp14WmBBujX_AQy-AVm-D_N0_UiUzAi3u7MxrqaQhvn91fT7ae3MfZgfnGPGgRO-Ul5ZuhE_wxd_d7bBXSzssxD7Cu0v9k8zQBw8q4nRw0/s640/NA+Equity+Misses+2016.png" width="640" /></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">Globally, actual stock market performance was less impressive than that of North American markets, with two notable exceptions, Russia and Brazil. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgh2QCvW0YusL0co6uiH8xDWF0WHEERoQtuDV7h2PBTDz6DC4fDLxIkTaPOXJtiGkLSYRs911cK8dPXf2T82CKzUAk_XF6LKoxTXr1rPdGWTIh9kAZsMHKkmhn46s6uVI2QorqL3tyk8mU/s1600/Actual+equity+performance+2016.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="378" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgh2QCvW0YusL0co6uiH8xDWF0WHEERoQtuDV7h2PBTDz6DC4fDLxIkTaPOXJtiGkLSYRs911cK8dPXf2T82CKzUAk_XF6LKoxTXr1rPdGWTIh9kAZsMHKkmhn46s6uVI2QorqL3tyk8mU/s640/Actual+equity+performance+2016.png" width="640" /></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;"><br /></span><span style="color: #b45f06; font-size: large;"><b>Investment Implications</b></span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-86844039422017175352016-11-12T19:09:00.000-08:002016-11-12T19:09:45.507-08:00Global Macro Reaction to President Trump<span style="font-size: large;">To the surprise of many, it's President Trump. </span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">US Equity ETF's Biggest Winners, EM Assets Biggest Losers</span></h3>
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<span style="font-size: large;">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. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbAzGxxwDprMfustyK6rtUfUx0bbaCVsK1eIq-TD84_yMdoFtrhlcyOv-ZVgkS_lvjCjcA59dgSi-AD61zEJ2o5idAI_DzE6a8kSmO9wmqvan4ryZZEYnfSW0naRj3h946u9DPaPUjkfs/s1600/ETF+Returns+Post+Election.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="434" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbAzGxxwDprMfustyK6rtUfUx0bbaCVsK1eIq-TD84_yMdoFtrhlcyOv-ZVgkS_lvjCjcA59dgSi-AD61zEJ2o5idAI_DzE6a8kSmO9wmqvan4ryZZEYnfSW0naRj3h946u9DPaPUjkfs/s640/ETF+Returns+Post+Election.png" width="640" /></span></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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%. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRVePZbvjY9Xwp5bMuXQkj-wT6l9YNA2NrG-_Vphp39zfStsbxRMLND20iMYzs_r7q11Mkrp4cSRdQKWNaqtj8bv9ooHLgU-QyEcLs_OuwM-NIR5kZYZFIq4l_sqnV0P44YZ9xDWj5BEI/s1600/Equity+ETFs+Post+Election.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRVePZbvjY9Xwp5bMuXQkj-wT6l9YNA2NrG-_Vphp39zfStsbxRMLND20iMYzs_r7q11Mkrp4cSRdQKWNaqtj8bv9ooHLgU-QyEcLs_OuwM-NIR5kZYZFIq4l_sqnV0P44YZ9xDWj5BEI/s640/Equity+ETFs+Post+Election.png" width="640" /></span></a></div>
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<span style="font-size: large;">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. </span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Interpreting the Global Macro Message from the Markets</span></h3>
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<span style="font-size: large;">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:</span><br />
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<ul>
<li><span style="font-size: large;">Repeal/replace Obamacare</span></li>
<li><span style="font-size: large;">Increase spending on infrastructure and defence</span></li>
<li><span style="font-size: large;">Reject the Paris Agreement on climate change </span></li>
<li><span style="font-size: large;">Reform and cut taxes</span></li>
<li><span style="font-size: large;">Reduce regulation of banks and other industries</span></li>
<li><span style="font-size: large;">Tear up NAFTA, reject TPP, raise tariffs on Chinese and Mexican imports</span></li>
<li><span style="font-size: large;">Tighten immigration, deport (some) illegal immigrants</span></li>
</ul>
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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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-18182119954465294842016-10-04T07:21:00.000-07:002016-10-04T07:21:17.156-07:00Global Monetary Spillovers and Bank of Canada Independence<span style="font-size: large;">In a recent post, I discussed <a href="http://tcglobalmacro.blogspot.ca/2016/09/the-breakdown-of-faith-in_14.html" target="_blank"><span style="color: #b45f06;">The Breakdown of Faith in Unconventional Monetary Policy</span></a>. 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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Evidence of Spillovers</span></h3>
<span style="font-size: large;">In a their paper, <a href="http://www.bis.org/publ/qtrpdf/r_qt1509i.pdf" target="_blank"><span style="color: #b45f06;">International Monetary Spillovers</span></a>, </span><span style="font-size: large;">Boris Hofmann and Előd Takáts of the Bank for International Settlements (BIS) state that:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
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<span style="font-size: large;">Jaime Caruana, General Manager of the BIS, in a recent paper entitled, <a href="http://www.bis.org/speeches/sp150430.pdf" target="_blank"><span style="color: #b45f06;">The international monetary and financial system: eliminating the blind spot</span></a>, makes the following observation:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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. </span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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. </span></blockquote>
<span style="font-size: large;">Caruana has identified four channels by which global liquidity conditions can spill over:</span><br />
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<ol>
<li><span style="font-size: large;">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);</span></li>
<li><span style="font-size: large;">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;</span></li>
<li><span style="font-size: large;">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 </span></li>
<li><span style="font-size: large;">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.</span></li>
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<span style="font-size: large;">Caruana concludes:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
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<span style="font-size: large;"><span style="color: #b45f06;">Implications of Spillovers for Canada</span></span></h3>
<span style="font-size: large;">For smaller, open DM economies like Canada, the spillovers from the major central banks’ UMPs are readily visible. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">When major central banks, including the Bank of Japan, ECB and BoE moved to NIRP, the Bank of Canada announced that <a href="http://www.bankofcanada.ca/wp-content/uploads/2016/05/boc-review-spring16-witmer.pdf" target="_blank"><span style="color: #b45f06;">its research showed that it, too, could lower its policy rate below zero if necessary</span></a>. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">The ultra-low interest rates imported through global financial markets, have led to a credit boom. </span><span style="font-size: large;">The credit boom has been characterized by heavy borrowing by Canadian households and some sectors of Canadian business, such as the energy sector. </span><br />
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<span style="font-size: large;">The heavy mortgage borrowing by households has contributed to overheated housing markets in Vancouver and Toronto. As I have argued <a href="http://tcglobalmacro.blogspot.ca/2016/06/china-stimulus-and-vancouver-house.html" target="_blank"><span style="color: #b45f06;">in a previous post</span></a>, 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.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;">Monetary Spillovers and Central Bank Independence</span></h3>
<span style="font-size: large;">This raises the important question of whether the central banks of smaller open economies, like Canada, can pursue independent monetary policy.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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 <span style="color: #b45f06;"><a href="http://www.slate.com/articles/business/the_dismal_science/1999/10/o_canada.html" target="_blank"><span style="color: #b45f06;">Paul Krugman</span></a> </span>in 1999,</span><br />
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<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
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<span style="font-size: large;"><a href="https://en.wikipedia.org/wiki/Impossible_trinity" target="_blank"><span style="color: #b45f06;">Wikipedia summarizes</span></a> with the help of the diagram below: "</span><span style="font-size: large;">The Impossible Trinity" or "The Trilemma", in which two policy positions are possible. If a nation were to adopt position <i><b>a</b></i>, 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.</span><br />
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<span style="font-size: large;">When Canada let its exchange rate float in 1970, it opted for position <b><i>b</i></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.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">In a paper entitled </span><span style="font-size: large;"><a href="https://www.kansascityfed.org/publicat/sympos/2013/2013Rey.pdf" style="color: #b45f06;" target="_blank"><span style="color: #b45f06;">Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence</span></a>,</span><span style="font-size: large;"> </span><span style="font-size: large;">Hélène Rey</span><span style="font-size: large;"> of the Kansas City Fed argues,</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">[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.</span></blockquote>
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<h3>
<span style="color: #b45f06;"><span style="font-size: large;">Implications for Canadian Monetary Policy</span> </span></h3>
<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">How will the future paths of the major central banks policies influence and constrain the policies of the Bank of Canada?</span><br />
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<span style="font-size: large;">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?</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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? </span><br />
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<span style="font-size: large;">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?</span><br />
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<span style="font-size: large;">If the BoJ and/or the ECB push policy rates further into negative territory, should the Bank of Canada be prepared to follow?</span><br />
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<span style="font-size: large;">If Japan adopts ‘helicopter money’ or central bank financed fiscal stimulus, should the BoC consider the same direction?</span><br />
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<span style="font-size: large;">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? </span><br />
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<span style="font-size: large;">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?</span><br />
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<span style="font-size: large;">These are tough and important questions that are not even being discussed in Canada.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-27476554901713450542016-10-02T10:03:00.000-07:002016-10-02T10:03:35.244-07:00Global ETF Portfolios for Canadian Investors: 3Q16<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 3Q16</span></h3>
<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbkumM4gdDP7xv7zH_65bZ8eY-_vBe9YKzfg2Akz86GgaLt5sZnWQm7flJvEtJBdqJE8I9psqVXd38iLipApSZYRIAkRLG6rhPZxjxhuCgT0iJmiDu-NQHwgXfzEU2OJrtYElgzQZLwrw/s1600/Global+ETF+Returns+3Q16.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="402" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbkumM4gdDP7xv7zH_65bZ8eY-_vBe9YKzfg2Akz86GgaLt5sZnWQm7flJvEtJBdqJE8I9psqVXd38iLipApSZYRIAkRLG6rhPZxjxhuCgT0iJmiDu-NQHwgXfzEU2OJrtYElgzQZLwrw/s640/Global+ETF+Returns+3Q16.png" width="640" /></span></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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).</span><br />
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<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance for 3Q16</span></h3>
<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5yqlP2HPDvHn2WdquMDFsaeb3d4ZNqKbmMZYJAEykRlXGD4yLi9mSYC7Me5dANp2FCpjYJQXBbJKG3gmOGao3hTsMIroz1QGpSmo_aXpiwyP4VSBnr5CHmTNGaLuwljmNoNz-sSHbbWw/s1600/Global+ETF+Portfolio+Returns+3Q16.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="392" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5yqlP2HPDvHn2WdquMDFsaeb3d4ZNqKbmMZYJAEykRlXGD4yLi9mSYC7Me5dANp2FCpjYJQXBbJKG3gmOGao3hTsMIroz1QGpSmo_aXpiwyP4VSBnr5CHmTNGaLuwljmNoNz-sSHbbWw/s640/Global+ETF+Portfolio+Returns+3Q16.png" width="640" /></span></a></div>
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;">Looking Ahead</span></h3>
<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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 <a href="https://www.frbatlanta.org/-/media/Documents/cqer/researchcq/gdpnow/RealGDPTrackingSlides.pdf" target="_blank"><span style="color: #b45f06;">Atlanta Fed's GDP Now</span></a> 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.</span><br />
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<span style="font-size: large;">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%. </span><br />
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<span style="font-size: large;">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". </span><br />
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<span style="font-size: large;">The key event in the final quarter of 2016 is, without a doubt, the US presidential election. <a href="http://business.financialpost.com/fp-comment/the-mostly-good-news-about-trump-for-canadian-conservatives" target="_blank"><span style="color: #b45f06;">While it can be argued</span></a> 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". </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2thJr7Dgyt9XOys9JVgXlopCtl4fvdfSFpwN9zlT1P2hMw725YdJGdNbeBOuB15E8-yuf2z8xsue5FsSaWU5cALK1jp3Zubo6iAvgeHYjh_-imq9eHnAc_q2jiBjecCAr3VzsA9QMXug/s1600/10yr+Govt+Yields+Sep+16.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><span style="font-size: large;"><img border="0" height="414" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2thJr7Dgyt9XOys9JVgXlopCtl4fvdfSFpwN9zlT1P2hMw725YdJGdNbeBOuB15E8-yuf2z8xsue5FsSaWU5cALK1jp3Zubo6iAvgeHYjh_-imq9eHnAc_q2jiBjecCAr3VzsA9QMXug/s640/10yr+Govt+Yields+Sep+16.png" width="640" /></span></a></div>
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<span style="font-size: large;">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.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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.</span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-42779202874769129832016-09-14T09:23:00.000-07:002016-09-14T09:23:22.740-07:00The Breakdown of Faith in Unconventional Monetary Policy<div class="tr_bq">
<span style="font-size: large;">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. </span></div>
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<span style="font-size: large;">Inside central banks, faith remains strong, as witnessed at the Jackson Hole meetings in August, where the keynote speaker, <a href="http://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm" target="_blank"><span style="color: #b45f06;">Fed Chair Janet Yellen concluded</span></a>,</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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. </span></blockquote>
<span style="font-size: large;">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. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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).</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<h3>
<span style="color: #b45f06; font-size: large;">The Critique of Unconventional Monetary Policy</span></h3>
<span style="font-size: large;">Perhaps the most damaging critiques of UMP have come from current and former monetary officials.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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 "<a href="http://www.bis.org/publ/work570.pdf" target="_blank"><span style="color: #b45f06;">Unconventional monetary policies: a re-appraisal</span></a>". The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">[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.</span></blockquote>
<span style="font-size: large;">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 <a href="http://www.wsj.com/article_email/the-federal-reserve-needs-new-thinking-1472076212-lMyQjAxMTA2MDAyNTIwNjU4Wj" target="_blank"><span style="color: #b45f06;">an op-ed in the Wall Street Journal</span></a>.</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">The conduct of monetary policy in recent years has been deeply flawed. </span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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. </span></blockquote>
<span style="font-size: large;">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, <a href="https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-sims-paper.pdf?la=en" target="_blank"><span style="color: #b45f06;">with the following assessment</span></a>:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<span style="font-size: large;">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,</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">James Grant, Publisher, Grants Interest Rate Observer: </span><br />
<blockquote class="tr_bq">
<span style="font-size: large;"><a href="http://www.fuw.ch/article/the-fed-is-now-hostage-to-wall-street/" target="_blank"><span style="color: #b45f06;">What is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis.</span></a> I think that this kind of intervention has not only not worked but it has been very harmful. </span></blockquote>
<span style="font-size: large;">John Hussman, President, Hussman Econometrics Advisors:</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;"><a href="http://www.hussmanfunds.com/wmc/wmc160905.htm" target="_blank"><span style="color: #b45f06;">By driving interest rates to zero</span></a>, 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. </span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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. </span></blockquote>
<span style="font-size: large;">Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;"><a href="http://moneyweek.com/russell-napier-give-everybody-in-china-a-credit-card/" target="_blank"><span style="color: #b45f06;">Negative interest rates</span></a> 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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">"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. </span></blockquote>
<blockquote>
<span style="font-size: large;"><a href="http://marketplace.eri-c.com/lots/russell-napiers-solid-ground-fortnightly---down-the-rabbit-hole-to-the-death-of-the-agent-4th-aug-2016-russell-napier" target="_blank"><span style="color: #b45f06;">At this moment</span></a> 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.</span></blockquote>
<span style="font-size: large;">A summary of the critique of Unconventional Monetary Policy would include the following points:</span><br />
<br />
<ol>
<li><span style="font-size: large;">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.</span></li>
<li><span style="font-size: large;">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.</span></li>
<li><span style="font-size: large;">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. </span></li>
<li><span style="font-size: large;">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.</span></li>
<li><span style="font-size: large;">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).</span></li>
<li><span style="font-size: large;">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.</span></li>
<li><span style="font-size: large;">Breakdown of faith in UMP threatens central bank credibility and legitimacy.</span></li>
</ol>
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<h3>
<span style="color: #b45f06; font-size: large;">What is the Future of UMP?</span></h3>
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<span style="font-size: large;">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.</span></div>
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<span style="font-size: large;"><br /></span></div>
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<span style="font-size: large;">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 "<a href="https://www.kansascityfed.org/publications/research/escp/symposiums/escp-2016" target="_blank"><span style="color: #b45f06;">Designing Resilient Monetary Policy Frameworks for the Future</span></a>". 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, <a href="http://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm" target="_blank"><span style="color: #b45f06;">Yellen suggested</span></a> that the tools of UMP would be resorted to once again: </span></div>
<br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
<span style="font-size: large;">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 <a href="https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-goodfriend-paper.pdf?la=en" target="_blank">argued that</a>, "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 <a href="https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-sims-paper.pdf?la=en" target="_blank">as follows</a>, "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 <a href="https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-kuroda-remarks.pdf?la=en" target="_blank">pushing ahead even further</a>,</span><br />
<blockquote class="tr_bq">
<span style="font-size: large;">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.</span></blockquote>
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<h3>
<span style="color: #b45f06; font-size: large;">The Risks That Lie Ahead</span></h3>
<span style="font-size: large;">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. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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 </span><span style="font-size: large;">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%. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">The fall in </span><span style="font-size: large;">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. </span><br />
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<span style="font-size: large;"><br /></span></div>
<div>
<span style="font-size: large;">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.</span></div>
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<span style="font-size: large;"><br /></span></div>
<div>
<span style="font-size: large;">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.</span></div>
TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0tag:blogger.com,1999:blog-3338983638234895144.post-62098142282637591302016-07-02T19:41:00.000-07:002016-07-02T19:41:10.628-07:00Global ETF Portfolios for Canadian Investors: 2Q16 Review and Outlook<span style="font-size: large;">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.</span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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 </span><span style="font-size: large;">risk aversion related to Brexit and </span><span style="font-size: large;">signs that Canada's real GDP growth had stalled in 2Q. </span><br />
<span style="font-size: large;"><br /></span>
<span style="font-size: large;">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. </span><br />
<span style="color: #b45f06; font-size: large;"><br /></span>
<h3>
<span style="color: #b45f06; font-size: large;">Global Market ETFs: Performance for 2Q16</span></h3>
<span style="font-size: large;">In 2Q16, with the USD depreciating 0.7% against the CAD, g</span><span style="font-size: large;">lobal 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. </span><span style="font-size: large;">The chart below shows 2Q16 returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.</span><br />
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<span style="font-size: large;">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%.</span><br />
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<span style="font-size: large;">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.</span><span style="font-size: large;"> </span><br />
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<span style="font-size: large;">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). </span><span style="font-size: large;"> </span><br />
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<span style="color: #b45f06; font-size: large;">Global ETF Portfolio Performance for 2Q16</span></h3>
<span style="color: #b45f06;"> </span><span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 3.7% in 2Q16. Among the global ETF portfolios that we track, r</span><span style="font-size: large;">isk 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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="color: #b45f06; font-size: large;">Looking Ahead</span></h3>
<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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 <i>GDP Now</i> 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%.</span><br />
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<span style="font-size: large;">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%.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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.</span><br />
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<span style="font-size: large;">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. </span><br />
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<span style="font-size: large;">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. </span>TC Global Macrohttp://www.blogger.com/profile/10884643963772946146noreply@blogger.com0