Chronic Dissonance: Boom or Bust?

From Wikipedia, the free encyclopedia:

In psychology, cognitive dissonance is the mental stress or discomfort experienced by an individual who holds two or more contradictory beliefs, ideas, or values at the same time, or is confronted by new information that conflicts with existing beliefs, ideas, or values. 

Leon Festinger's theory of cognitive dissonance focuses on how humans strive for internal consistency. When inconsistency (dissonance) is experienced, individuals tend to become psychologically uncomfortable and they are motivated to attempt to reduce this dissonance, as well as actively avoiding situations and information which are likely to increase it.

I admit to experiencing chronic dissonance these days. My views on global markets are influenced by two contradictory beliefs. I am trying not to actively avoid information which is likely to increase the dissonance and my discomfort. The dissonance makes investment decisions difficult because one set of beliefs tells me to add to my risky investments in equities and high yield credit, while the other tells me to reduce risk.

I read a lot of macro research and strategy produced by some of the brightest people in the investment industry. I like to follow analysts who are challenging and engaging. I enjoy differing points of view, which are always out there and also what makes a market.

What has struck me recently, however, is how divergent the views of some of my favourite analysts have become. The divergence in their views and investment recommendations, I believe, stems from their differing analytical frameworks.

Two Frameworks 

One framework emphasizes high frequency data watching combined with momentum investing (or, for short, the HFMI approach). This approach closely follows developments in macroeconomic data to track the business cycle, inflation trends and central bank policy guidance to assess the likely direction of interest rates, exchange rates, equity prices, commodity prices and credit spreads.

Leading practitioners of this framework are presently focused on the recent strength of the US economy (especially the US labor market), the increasing likelihood of Fed tightening this summer, and the stimulative economic effects of both the oil price decline and easing by non-US central banks. Strategists who employ this framework tend to be quite bullish, favouring the "growth trade", characterized by overweight positions in equities, select commodities and credit and underweight positions in government bonds, especially long duration bonds.

Another framework emphasizes balance sheet analysis combined with capital preservation (or the BSCP approach). This approach follows less-watched data on capital flows, national and sectoral balance sheets, debt levels, credit spreads and market liquidity. It interprets high-frequency economic data against the backdrop of balance sheets and valuation levels. 

Strategists who employ this framework tend to be much more cautious about the economic and investment outlook. They tend to emphasize the continued rise in global debt ratios, the overbuilt or bubble conditions that exist in some key economies and sectors, and the persistence of deflationary pressures. They worry about the impact of rapid decline in crude oil prices and the rapid rise in the value of the US dollar and their potential impact on financial stability.

When I worked for a large institutional pension fund, I had the privilege of meeting Ray Dalio and several other fine analysts and
strategists at Bridgewater Associates. Dalio has posted a 30-minute video on YouTube on "How the Economic Machine Works" that every investor should take the time to watch. Within the first minute of the presentation, Dalio outlines the three main drivers of the the economy:

• Productivity growth;
• the short-term debt cycle (or the business cycle); and
• the long term debt cycle.

The interaction of these three drivers determines the path of economic growth and inflation. Productivity growth, the key element of longer-term economic prosperity, does not draw much attention from investors who tend to focus on shorter-term factors that influence the ups and downs of the economy. 

The short-term debt cycle, or the business cycle, is the focus of practitioners of the first framework that I mentioned above, the HFMI approach. The long-term debt cycle is the focus of practitioners of the second framework, the BSCP approach.

The advantage of the HFMI approach is that, most of the time, short-term business cycles determine the ups and downs of the economy and markets. The main disadvantage of the HFMI approach is that it tends to miss (and be surprised by) turning points in long-term debt cycles, as occurred in 2008-09 when the US housing bubble burst, triggering rapid deleveraging, a disastrous tightening of liquidity and a meltdown of a wide range of asset prices.

The advantage of the BSCP approach is that it actively tracks the long-term debt cycle and, if astute, can prepare for the large downturns in economic activity and drawdowns in investment returns that occur when bubbles burst. The main disadvantage of the BSCP approach is that the triggers for the bursting of bubbles are quite unpredictable. It can be true that a dangerous bubble has developed, but without a trigger the bubble can persist for a long time. The over-cautious BSCP investor can miss out on much of the benefit of persistent market rallies in bubble periods.

The current situation

A pickup in US growth in 2H14, a dramatic halving in the price of crude oil as supply grew faster than demand, and renewed monetary easing by the BoJ and the ECB have made practitioners of the HFMI approach more optimistic about global growth. Some HFMI strategists have gone all in for the growth trade.

But, here is the current concern from the BSCP approach. In the period since the Great Financial Crisis (GFC), government policies have aimed to support growth and fight deflationary tendencies. These policy measures have been taken to extraordinary lengths. The US and China supplied very large scale fiscal stimulus in the depths of the crisis. Central banks in the large DM economies took their policy interest rates down to close to zero and have held them there for six years. The Fed, the BoE, the BoJ and the ECB have all undertaken quantitative easing, dramatically expanding the size of their balance sheets. In some countries, including the UK, Canada, Australia and Hong Kong, low interest rates and easy credit availability led to large increases in housing prices and household debt ratios.

Since the GFC, China's central bank, the PBoC, has encouraged the fastest credit growth in memory. For a while, this supported high levels of economic growth in China and other emerging market economies. In the process, China became the world's largest economy (according to new measures of purchasing power parity from the IMF). However, it became apparent that a byproduct of the Chinese credit binge was that housing, infrastructure and industrial capacity all became seriously overbuilt. However, the Chinese economy is now slowing more than expected (and probably much more than indicated by official GDP figures). Other large EM economies, some with large trade ties to China such as Brazil, and others for geopolitical reasons, such as Russia and Turkey, have also slowed sharply. Overhanging this situation is China's housing bubble, the magnitude of which is quite comparable to that of the US housing bubble prior to the GFC. 

What is unknown is whether the Chinese authorities will be able to let the air out of the bubble without the crash witnessed in the US. The Chinese government began to adopt more restrictive housing policies some time ago. Now, with the the housing sector contracting and the economy slowing sharply, the PBoC has begun to ease, cutting the policy rate and lowering banks' required reserve ratio.

With the PBoC easing and the US Fed expected to begin tightening soon, the Chinese yuan's loose peg to the US dollar has come under pressure. With the USD surging in recent months and the CNY still maintaining a loose peg, the Chinese currency has appreciated dramatically against the Japanese Yen and currencies of other Asian competitors. The PBoC has recently permitted the trading band of the CNY to weaken against the dollar. A devaluation of CNY could become necessary (or unavoidable) if the Chinese economy cools too fast. That would lower the prices of a wide array of consumer goods imported from China by the US and other DM economies, adding to global deflationary pressures.

Countries like Canada and Australia have high stakes in how China's overcapacity problem is managed. Already these two commodity-exporting economies have been hit with sharp deteriorations in their terms of trade, a big negative shock to their gross domestic incomes and corporate profits, which has led their central banks to cut their policy rates. The CAD and AUD have weakened sharply. Housing markets are cooling in resource producing regions of these countries and this is likely to spread over time as commodity prices seem likely to remain depressed for some time.

Could the Fed's expected rate hike be unfortunately timed to coincide with a deepening slowdown in China and a new global deflationary shock? This is the dissonance that I am experiencing. How about you? Is it boom or is it bust? Is it go all in for the growth trade or should we focus on capital preservation after US bond and equity prices have reached all-time highs? As a Canadian investor, I remain in a cautious portfolio, with 45% equities, 25% bonds and 30% cash with a high exposure to US dollar denominated assets. When the dissonance diminishes, I should be able to deploy the cash at more attractive valuations for equities, bonds or both. 







        

Why Poloz Took Out Insurance

To read the Canadian financial press, Bank of Canada Governor Steven Poloz "shocked" markets when he cut the policy rate on January 21. Some economists, who were still forecasting that the BoC's next move would be a rate hike in late 2015, covered their tracks by highlighting that Poloz noted that the rate cut was insurance against downside risk to the economy. These analysts seemed to imply that Poloz was just being cautious in response to an "uncertain" impact of the sharp drop in the price of crude oil.

In fact, the Bank of Canada had a very good idea of what the economic impact of the drop in the crude oil price would be. The BoC's macroeconomic projection model has the acronym ToTEM, short for Terms of Trade Economic Model. The model recognizes that as a mid-sized, high-income, technologically-advanced, commodity-exporting economy, Canada's economic performance is closely tied to movements in the prices of the commodities that it exports.

In the final two pages of its January Monetary Policy Report, the BoC clearly laid out its estimates of the impact that the drop in crude oil prices would have on the economy. Using the ToTEM projection model, the BoC estimated that, assuming no change in the policy rate, the drop in the crude oil price from $110/bbl to an average of $60/bbl in 2015-16 would cut real GDP by 1.4%, real consumption by 1.3%, and real investment spending by 5.2%. 

Forecasters can argue that they they were "shocked" because they don't have sophisticated projection models that take full account of the impact of changes in Canada's commodity prices and terms of trade. But, in my opinion, this is no excuse. If these forecasters had carefully examined how sharp declines in Canada's commodity price index had affected the economy in the past, they should have known that a cut in the policy rate was much more appropriate and much more likely than a rate hike.

The 2014-15 Commodity Price Shock

The chart below shows the main indicators of Canada's current massive negative commodity price shock. While energy prices, which have a weight of just under 50% in the commodity price index, are the current focus of attention, it is worth noting that Canada's non-energy commodity prices have fallen about 16% since hitting their all-time high in April 2011. The horizontal scale shows the number of months before and after crude oil and gasoline prices hit their low point. The commodity price index was down almost 40% from a year earlier in January 2015. Gasoline prices, reflecting the sharp drop in crude oil prices, were down almost 30% from a year ago, implying a drop of about 15% in the CPI for energy products. Industrial production (IP) was only available through November 2014, when it was up 2.1% from a year earlier.

The debate in early January, before the BoC cut the policy rate, was about what impact the sharp drop in the price of crude oil would have on Canadian inflation and growth. Most forecasters had not fully factored in impact the the drop in the price of gasoline would have on the total inflation rate. And almost none of the forecasters had factored in any significant impact on growth.

What Happened in Previous Commodity Price Shocks?

The current period is not the first time that Canada's commodity price index has collapsed. There have been three previous occurrences in the past 30 years. What happened to growth, inflation and the Canadian dollar in those periods? The chart below shows how the indicators performed on average during three similar shocks in the past. As in the chart above, the horizontal scale shows the number of months before and after crude oil, gasoline prices, and the CPI for energy hit their low point.

The three previous commodity price shocks occurred in 1986, 1998 and 2008-09. The chart shows that on average, the commodity price index fell about 25% y/y at the low point of these shocks. The CPI energy fell 15% y/y on average at its' low point, mainly reflecting lower crude oil and gasoline prices. The Canadian dollar depreciated about 12% from its peak on average. The key is what happened to industrial production: on average it fell 5% y/y, with the low point occurring around the same time or shortly after crude oil and gasoline prices hit their lows.

Only in 2008-09 did the commodity price collapse coincide with a recession, but in all three previous episodes, industrial production, the key indicator of the business cycle, slowed sharply when commodity prices fell. (Separate charts for each commodity price shock are shown at the end of this post.)

In all three previous commodity price collapses, the Bank of Canada cut its policy rate. Why was it a "shock" to forecasters that the BoC cut again in January? Why did Poloz take out insurance? Because as history tells us, and as the the ToTEM model projected, there was a very high risk of not only a sharp drop in inflation, but also a sharp drop in growth.

Did the 25 basis point policy rate cut buy enough insurance? Not likely. The BoC's January projection assumed that the price of crude oil would average $60/bbl over 2015-16. As Poloz noted in January, "Obviously, [the downside] risks would be even more material if oil were to average $50 a barrel". A mere 25 basis point rate cut is unlikely to mitigate significantly the impact of one of the biggest commodity price collapses of the past three decades.

For those who want to study each of the three previous commodity price collapses in more detail, individual charts for 1986, 1998 and 2009 are shown below.

Canadian Consensus Blows Apart

The Bank of Canada's decision on January 19, to cut the policy rate to 0.75% from 1.00%, took forecasters by surprise. The only thing that surprised me (see here) about the move was that it happened in January and not at the next meeting in March. The BoC clearly saw the magnitude of the negative shock of the plunge in the price of crude oil as justifying the surprise. Indeed, markets were already pricing in a 50% chance of a rate cut by June, so were less surprised than economic forecasters.

None of the economics groups at Canada's Big 5 banks expected a rate cut in 2015. Indeed, four out of five expected the policy rate to rise, beginning some time in the second half of the year (Scotia Bank was the exception). The rate hike forecasts were predicated on forecasts of modestly above trend real GDP growth, a gradually shrinking output gap, and inflation moving up to the 2% target by the end of 2016.  

Although the price of crude oil had fallen by about half by mid-January, no major changes had been made to private sector growth forecasts for 2015, and the inflation outlook treated the oil price drop as a temporary phenomenon that could be "looked through".

This consensus view of December was blown apart by the BoC's action and the accompanying Monetary Policy Report. Forecast revisions have begun and, for some of the banks, are still a work in progress. Looking at their websites, it is possible to get an idea of the magnitude and direction of the revisions.

TD Economics was the first off the mark with a complete re-forecast. It lowered the assumed 2015 average price for crude oil to $47/bbl from $68/bbl in its' December forecast. The 2015 real GDP growth forecast was cut from 2.3% to 2.0%. The CPI inflation forecast for 2015 was cut to 0.4% from 1.5% in the December forecast.

The chart below shows the evolution of CPI inflation forecasts since the Bank of Canada's October Monetary Policy Report.

Forecasters still view the decline in the price of crude oil as causing a temporary drop in the inflation rate.  The forecast for inflation at the end of 2016 is the same or possibly higher than it was in December. Of course, the forecast level of the CPI is lower, but the rate of inflation at the end of 2016 has barely budged. This outcome is to be expected in the Bank of Canada's projections because the Bank's mandate is to return inflation to the 2% target over 6 to 8 quarters. Private sector economists don't have to mimic the BoC forecast, but they pretty much always do.

So how has this weaker growth and lower inflation outlook altered forecasts for the Bank of Canada's policy rate? The following charts compare the minimum, median, and maximum policy rate forecasts made in December with the most current forecasts.

In December, all forecasters saw the BoC policy on hold at 1.00% through mid-year 2015 and then

moving up, with 4Q16 forecasts ranging from 1.75% to 2.75%. 

By the end of January, the forecasts are all over the map. One bank, RBC, sees the cut to 0.75% as being a one and done move, with the BoC reversing course by the end of June and still moving the policy rate up

to 2.75% by 4Q16. The median forecast expects another rate cut to 0.50% in March, before the BoC goes on hold for the rest of 2015 and then raises to policy rate to 1.50% by the end of 2016. One bank, TD, expects the BoC to hold the policy rate at 0.50% through 3Q16, and then to raise it to 1.00% in 4Q16.

 
The actual outcome will depend on how low oil prices move and how long they stay low. It is not inconceivable, if oil prices fall to $40/bbl or lower and stay down, that the BoC might lower the policy rate to its 2009 low of 0.25%. 

Some economists have suggested that the cut to 0.75% and possible further cuts risk stoking a housing bubble and eventually a crash when rates eventually rise. This seems unlikely. House prices in the oil producing regions are already falling as oil incomes plummet. In oil consuming regions, a sharply lower Canadian dollar is making imports more expensive, offsetting much of the windfall from lower gasoline prices. The banks have been slow to lower mortgage rates, so the risk of fuelling a housing bubble seems limited.

  

The BoC Should Open the Door to a Rate Cut Now

My old friend, David Wolf, recently of Fidelity Investments, but previously an Advisor at the Bank of Canada, attracted headlines last week in response to an investment commentary which he provocatively titled "Canada's Oil Slick" (see here). 

Wolf argues that, for many years, Canada has enjoyed a virtuous cycle: rising commodity prices fuelled a strong Canadian dollar, which boosted confidence, purchasing power, borrowing, consumer spending, housing prices and other asset prices. Now that virtuous cycle has turned vicious; all of these forces are working in the other direction. 

Some economists argue that the negative effects of lower oil prices will be more than offset as US and Canadian consumers get a boost from cheaper gasoline prices and Canadian exporters benefit from a lower Canadian dollar.

But Wolf contends that most economists and markets are underestimating the second and third round effects: the vicious cycle of falling commodity prices, a weakening Canadian dollar, falling confidence, slowing borrowing, falling asset prices and weakening spending that will follow the crash in oil and other commodity prices. 

As the economy and asset prices weaken, Wolf argues, "the probability that the Bank [of Canada] does eventually have to put interest rates back at zero has increased substantially". He suggests that, "The Bank of Canada does have a bit of room left to stimulate, although it will likely be hesitant to use it in the near term, partly to avoid the risk of exacerbating the household imbalances that have grown much larger since the crisis."

I believe that, in this debate, David Wolf's view is more likely to prove accurate. While I am in broad agreement with his assessment, in my opinion, he fails to mention one important link in the virtuous cycle that has turned vicious. When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports. 

When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending. While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.

What is noteworthy about the chart above is that the depreciation of the Canadian dollar, significant as it has been, has not kept pace with the deterioration of the commodity terms of trade. Even if oil and other commodity prices stabilize at current levels, the Canadian dollar needs to fall further, to below 80 US cents (or alternatively USDCAD needs to rise above 1.25), to have a chance to offset the negative impact of the terms of trade deterioration on growth and inflation.   

The Bank of Canada will make a policy rate decision and release an updated projection for the Canadian economy on January 21. The biggest change will be in the inflation projection. The table below shows the Bank of Canada's Total CPI inflation projection made in its October Monetary Policy Report (MPR) and JP Morgan's latest Canadian inflation forecast which incorporates most of the recent decline in crude oil prices.

The JP Morgan forecast anticipates that CPI inflation will turn negative in 2Q15 (as I predicted here) before edging back toward 1% by 4Q15 assuming that the price of oil rebounds toward $90 per barrel by the end of 2015.   If, as I believe likely, crude oil prices remain depressed for a much longer period of time, say well into 2016 or 2017, inflation will likely fall into negative territory in early 2015 and remain there for some time.

With such an outlook, the Bank of Canada needs to pay full attention to defending its inflation target and supporting inflation expectations around 2%. The most effective way to do this in the near term is to provide guidance in the January 21 policy rate announcement and the Monetary Policy Report that the BoC stands ready to cut the policy rate if inflation moves persistently below the 1-3% target band.  

The Global Inflation Outlook for 2015

As far as the near-term outlook for asset prices is concerned, I believe that the path of global inflation is more important than the prospects for global growth. I reviewed the consensus forecast on global growth in a recent post, so now I turn to the inflation outlook. Last year, I presented the consensus outlook for inflation and, motivated by an insightful piece by Russell Napier which argued the case for strong global deflationary pressures, I also laid out an Inflation Scenario and a Deflation Scenario. By the end of 2014, Napier's prediction of a deflationary scenario was clearly playing out.

There are three things to know about the global inflation outlook:

• 2015 global inflation is likely to be the lowest on record;
• Inflation is lower in DM, but is falling faster in EM;
• Inflation drivers are much weaker in EM than in DM.

2015 Global Inflation Lowest on Record

Global inflation has consistently fallen short of expectations since 2013. This has occurred in spite of unprecedented efforts by central banks – in the form of negative real interest rates and massive Quantitative Easing – to fight disinflation.

Last year, global inflation for the entire set of world economies was expected by the IMF to edge up from 3.7% at the end of 2013 to 3.8% by the end of 2014. By October 2014, the IMF had lifted its year-end 2015 forecast to 3.9%. Meanwhile, a year ago, JP Morgan economists expected their measure of global inflation (for 39 major economies) to edge up to 2.9% in 4Q14 from 2.8% in 4Q13. JPM economists now expect that global inflation fell to 2.3% in 4Q14. JPM's 2015 global inflation forecast is now 2.4%, which appears to be the lowest forecast on record. 

But these forecasts, made between early October and mid-December, were already DOA*. While crude oil prices had already dropped sharply to around $65 per barrel in mid-December from around $95 per barrel in early September, economists were just beginning to factor in the impact that lower fuel prices would have on inflation. Since then, the price of crude has dipped below $50/bbl and looks likely to remain depressed for a considerable period of time.

* dead on arrival

In most countries, inflation can be expected to be weaker than the consensus forecasts. While US growth has picked up, growth in the Eurozone, Japan and most emerging markets has been disappointing and still shows signs of slowing. Considerable slack remains in the global economy. Wages are not accelerating. Commodity prices, led by crude oil, are plunging. Inflation expectations are falling. Deflationary forces are becoming entrenched despite central bank efforts.

DM inflation is lower, but EM inflation is falling faster

Inflation in Developed Market (DM) economies fell to just 1.2% in 2013 and remained unchanged in 2014, undershooting forecasts made a year ago by JPM (1.7%) and the IMF (1.9%). In 2015, JPM now expects DM inflation to edge down to 1.1%. The IMF estimate, reflecting a slightly broader definition of which economies qualify as DM, is for inflation to rise from 1.7% in 2014 to 1.9% in 2015.

Inflation in Emerging Market (EM) economies fell to 3.6% in 4Q14, according to JPM’s estimate, undershooting its forecast made a year ago of 4.2%. In 2015, JPM expects EM inflation to rise to 3.8%, while the IMF estimate (for a broader group of countries) is for a decline from 5.7% at year-end 2014 to 5.4% at the end of 2015.

Inflation drivers are stronger in DM economies than in EM

The balance between aggregate supply and aggregate demand is only one driver of inflation and often is not the most influential factor. The concept of an economy’s domestic capacity (or output gap) is of declining importance in world of globalized supply chains.

The chart below shows my rough estimates of several inflation drivers in the major economies. They combine the effects of an estimate of economic slack; monetary conditions (the combined effect of the real central bank policy rate and movements in the foreign exchange rate); and changes in inflation expectations.

Before going further, I would caution that I have normalized and weighted the contributions from the various drivers in a consistent but subjective fashion that accords with my judgment. The scale of the chart has less meaning than the direction of the impact of each of the drivers for the individual countries.

Given the preceding caveat, the chart suggests that the largest downward push on inflation in the DM economies is occurring in the United States. The US economy is expected to grow above trend but still has a large output gap, so economic slack remains a deflationary force. Monetary conditions are tightening as the real policy rate rises and the US dollar has appreciated against most world currencies. Inflation expectations are stable based on the the consensus inflation forecast but are declining based on breakeven inflation rates between nominal US Treasuries and TIPs. 

In the UK, where the Bank of England backed away from its intentions to raise the policy rate in 2014, economic slack and monetary conditions both point to slight upward pressure on inflation but expectations point solidly in the other direction. 

In the Eurozone, where inflation has already turned negative, economic slack still weighs on inflation and inflation expectations are stuck around zero. Monetary conditions, with a zero real policy rate and depreciating currency, are supportive but not strong enough to move inflation higher.

In Japan, weak growth, economic slack and weak inflation expectations continue to weigh on inflation while highly stimulative monetary conditions, mainly achieved by the weakening of the Yen, struggle to turn the tide. 

In Canada, neither economic slack nor monetary conditions are providing much impetus to inflation. On the monetary front, Canada has one of the highest real policy rates among DM countries but has experienced a sharp currency depreciation as the terms of trade have weakened. Inflation expectations were rising gradually prior to the recent plunge in crude oil prices, but this is likely to change as inflation forecasts are marked down over the next month or so to reflect lower energy prices. Similarly, Australia appears subject to moderate deflationary impulses.

Among the EM economies, deflation pressures seem strong in China, India, Brazil and Mexico. Growth is running below trend in all of these economies and slack is developing. Monetary conditions are disinflationary in all four economies. Inflation expectations appear to be falling in China, India and Mexico. The exceptions in the EM economies are Korea, where the economy has been operating above trend, and Russia, where currency depreciation has fuelled strong inflation expectations. 

Conclusions

Global inflation appears likely to fall to a new record low in 2015. The plunge in the price of crude oil has not yet been fully factored in to 2015 inflation forecasts. In DM economies, where inflation was already low at 1.2% at the end of 2014, a sharp decline is expected in early 2015 as lower transportation and heating fuel prices feed through into consumer prices. The Eurozone's annual inflation rate dipped into negative territory in December. Japan's inflation rate could turn negative again once the effect of the 2014 consumption tax hike falls out of the calculation. Headline inflation rates are likely to fall below central bank target ranges in the UK, Canada and Australia in 1Q14. In EM economies, inflation drivers point to further downward pressure on inflation in the major economies with the exception of Russia, where currency weakness is driving up already high inflation. 

In this strongly deflationary environment, the consensus forecast anticipates that central banks in the US, UK, Canada, Australia, Brazil and Mexico will all raise their policy rates by 25 to 75 basis points. Barring a quick and sharp reversal in crude oil prices, such rate hikes could prove a serious policy mistake.

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. 

Global ETF Portfolios: 2014 Returns for Canadian Investors

Global ETF portfolios performed well for Canadian investors in 2014. Much of the strong performance was attributable to an 8.4% depreciation of the Canadian dollar relative to the USD that provided a tailwind and proved quite profitable for Canadian investors in global ETFs.

Global economic developments were very mixed with lots of big misses by forecasters: 

• Global growth was a bit weaker than expected in 2014 and global inflation was significantly weaker than expected.   
• Global growth divergences increased as US, UK, China, India, Canada, Australia and Korea grew at or above expectations, while Japan, Eurozone, Brazil, Russia and Mexico grew much slower than expected. Most Emerging Market economies grew well below trend with India and Korea being notable exceptions.  
• Global inflation fell to its lowest in at least a decade, compared with forecasts at the beginning of 2014 of a meaningful rise in global inflation. The Eurozone, China, UK and Korea all posted much lower than expected inflation. 
• Global central bank policies diverged, with the US Fed ending its QE program and preparing markets for an increase in the policy rate in 2015, while the BoJ, ECB, and PBoC eased policy. Russia and Brazil were forced to hike policy rates to support their currencies. 
• The USD appreciated against virtually all global currencies.
• Led by crude oil, commodity prices plunged, particularly in the September to December period, putting significant pressure on the currencies of commodity exporting countries, including Canada.
• Bond yields fell virtually everywhere, with Russia being a notable exception.

From my perspective, a key development for markets came at the end of August, when Fed Chair Janet Yellen delivered a speech at the Jackson Hole meeting of central bankers that presented a balanced view on the outlook for the economy and the need for normalization of US monetary policy. The market had been expecting Yellen to continue with the dovish talk that had been her trademark. In a September post, I referred to the market reaction to Yellen's speech as the beginning of "Exit Ennui" as the Fed prepared markets not only for an end of QE, but for a normalization of the policy rate in 2015. As I will show in this post, global ETF performance in the final four months of 2014, as Exit Ennui took hold, was far weaker than prior to Yellen's Jackson Hole speech. With other central banks showing little or no interest in normalizing monetary policy, the appreciation of the USD accelerated. With the major economies outside the US locked into subpar growth, the rising USD created an environment in which crude oil prices collapsed and most other commodity prices continued to weaken. 

For its part, the Bank of Canada continued to signal that it was in no hurry to raise its policy rate (see my November post). After all, Canada had begun to normalize its policy rate back in 2010, raising it to 1.00% from its low of 0.25%, and already had a tighter monetary policy than other major DM economies. In this environment the Canadian dollar (CAD) depreciation versus the USD accelerated following Yellen's speech. 

Global Market ETFs: Performance for 2014

In 2014, with the USD appreciating 9.3% against the CAD, the best global ETF returns for Canadian investors were in USD denominated bond and equity ETFs. The worst returns were in commodities, Eurozone and Japanese equities and local currency Emerging Market bonds. The chart below shows 2014 returns, including reinvested dividends, for the ETFs tracked in this blog, in both USD terms and CAD terms.

Global ETF returns varied dramatically across the different asset classes in 2014. In USD terms, 10 of the 19 ETFs we track posted positive returns, while 9 ETFs posted losses for the year. In CAD terms, 17 of 19 ETFs posted gains, while just 2 posted losses. 

The best gains were in the US long bond ETF (TLH) which returned a stunning 24.8% in CAD. The S&P500 ETF (SPY) was second best, returning 24.0% in CAD. Other gainers included US Investment Grade Bonds (LQD), which returned 18.2% in CAD; USD-denominated Emerging Market bonds (EMB) 15.8%; Canadian Long Bonds (XLB) 15.4%; Canadian real return bonds (XRB) 14.6%; US small cap stocks (IWM) 14.5%; US inflation-linked bonds (TIP) 12.8%; Canadian equities (XIU) 11.9%; and US high yield bonds (HYG) 11.3%.

The worst performer, by far, was the commodity ETF (GSG), which returned -33.0% in USD and -26.8% in CAD. Eurozone equities (FEZ), returned -7.0% in USD and -1.4% in CAD. Seven other ETFs posted losses in USD terms, but showed gains in CAD terms, including non-US inflation-linked bonds (WIP) +9.1% CAD, non-US sovereign bonds (BWX) +6.9% CAD; the gold ETF (GLD) +6.9% CAD; Canadian corporate bonds (XCB) +6.5% CAD; Emerging Market equities (EEM) +5.0% CAD; Emerging Market Local Currency Bonds (EMLC) +3.3% CAD; and Japanese equities (EWJ), which gained 2.5% in CAD terms.  

Global ETF Portfolio Performance for 2014

In 2014, the Canadian ETF portfolios tracked in this blog posted strong returns in CAD terms when USD currency exposure was left unhedged, but only moderate returns when USD exposure was hedged. In a November post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 11.7% in CAD when USD exposure was left unhedged, but just 7.0% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 12.3% if unhedged, but 7.6% if USD hedged.

Risk balanced portfolios outperformed in 2014 after a relatively poor year in 2013. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 19.9% in CAD terms if USD-unhedged, but had a less stellar gain of 10.2% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 13.4% if USD-unhedged, but just 6.2% if USD-hedged.

Returns Weakened as "Exit Ennui" Took Hold

As mentioned, asset markets lost significant momentum in the last four months of 2014 after Janet Yellen spoke at Jackson Hole. The chart below shows global ETF returns, in local currency terms, dividing the year into the first eight months and the final four months.

In the January-August period, virtually all ETFs posted positive returns with the exception of modest losses in commodities (GSG) and Japanese equities (EWJ). In the September-December period, 13 out of the 19 ETFs posted negative returns in their local currency. Bucking that negative trend were US equities and US and Canadian long bonds. Commodities, Gold, Emerging Market ETFs, non-US equities, Inflation-Linked Bonds and High Yield bonds all posted negative returns as Exit Ennui took hold. 

As a consequence, ETF portfolio returns, while still positive thanks to a 6.9% appreciation USD versus CAD, lost significant momentum over the September-December period. In USD terms, all of the portfolios posted losses in the final four months of 2014.

This can also be seen in the tracking of weekly portfolio returns since the beginning of 2012. Two significant portfolio drawdowns have occurred over this period: the Taper Tantrum drawdown of 2013, when Fed Chair Bernanke indicated that the Fed would taper the QE program, and Exit Ennui drawdown, when Fed Chair Yellen indicated that the Fed would begin to normalize the policy rate.

While the equity-heavy 60/40 portfolio performed best over the past three years, the more conservative 45/25/30 portfolio was the second best performer as it suffered less in the drawdowns and was generally less volatile. 

As we enter 2015 in a continuing uncertain environment, characterized by US economic strength, significant global divergences in growth and central bank policies, and collapsing oil and other commodity prices, remaining well diversified with an ample cash position continues to be a prudent strategy. 

The Outlook for Global Growth in 2015

It's that time of year to look ahead to the prospects for global growth. I posted a similar outlook a year ago and recently followed up with an assessment of those 2014 forecasts. I should be clear about why I find this exercise useful. I assemble a global growth outlook not because I have faith in forecasts. I do it because I'm looking for a "consensus view" on the year ahead, a view that is presumably already built into market prices. The consensus view, as Howard Marks of Oaktree Capital recently reminded us, is "what 'everyone knows' [and] is usually unhelpful at best and wrong at worst". What will move markets in 2015 is not the current consensus forecast, but the ways in which actual growth diverges from that consensus.

With the foregoing caveat in mind, there are four things to know about the outlook for global growth:

• 2015 growth forecasts have edged down over the past year;
• 2015 growth is currently expected to be better than 2014; 
• Most DM economies are expected to grow above trend, while most EM economies are expected to grow below trend;
• Leading indicators suggest somewhat slower growth than forecast for most countries.

2015 Forecasts have Edged Down

Last year at this time, global growth was expected by the IMF to pick up to 3.8% in 2014 while JP Morgan economists expected a more modest acceleration to 3.3%. Instead, 2014 growth is now estimated to have remained flat at the same disappointing 3.0% pace as in 2013.

The focus of economists now is on growth forecast for the year ahead, but it is worth noting that views on 2015 growth have edged down over the past year. 

This year, forecasters tell us once again that global growth will pick up in 2015 to 3.8% (IMF October forecast), or to 3.5% (Barclays December forecast), or to 3.3% (JPMorgan December forecast). These forecasts are presented as upbeat news, but the reality is that the 2015 forecast for has faded from the 4.0% forecast published by the IMF in July 2014.

2015 growth expected to be stronger almost everywhere

As was the case last year,  growth is expected to pick up in most countries in 2015. Economies with the largest forecast growth pickup include Japan (1.4% in 2015 vs 0.2% in 2014), Mexico (3.2% vs 2.2%), Eurozone (1.6% vs 0.9%), US (3.0% vs 2.3%) and India (6.0% vs 5.3%). Modest growth improvements are also expected in Australia and Korea. In Canada, 2015 growth is expected to match the 2014 pace of 2.4%.

Growth is expected to slow in UK (2.8% vs 3.0%) and China (7.2% vs 7.4%), while Russia is expected to fall into recession (-3.3% vs +0.6%).

Once again: DM above trend, EM below trend

While global growth is expected to be a bit stronger in 2015, the 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 DM economies are expected to grow above their trend (or potential) rate of growth, while EM economies are expected to grow below their trend rate. In the chart below, the blue bars show the 2015 growth forecast versus the OECD estimate of the trend growth rate for each economy.

In 2015, the larger DM economies are expected to grow at an above trend pace, while Australia is expected to grow at trend. In contrast, all of the major EM economies, except Mexico (0.3% above trend), are expected to grow well below trend, especially Brazil (3.0% below trend) and Russia in recession (6.5% below trend, off the chart). 

Leading indicators support most growth forecasts

In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) versus trend for each of the economies. These CLIs generally support weaker 2015 growth than economists are forecasting, with a few exceptions.

In the DM economies, the leading indicators suggest that growth could surprise on the downside in US, Japan and Canada.

In the EM economies, CLIs suggest that growth could be weaker than expected in China and Mexico, but stronger than expected, although still below trend, in India, Brazil and Russia. Korea is an exception, where the CLI suggests strong above-trend growth.

Conclusions and Questions

2014 turned out to be a year in which global growth was modestly disappointing, but the real story for markets was the divergences in real GDP growth. Will the divergences of 2014 continue? If so, the US Fed and the Bank of England will likely begin to tighten monetary policy in 2015, while the ECB, BoJ and PBoC will likely maintain their current accommodative policies or ease further. In such a scenario, the US$ is likely to continue to appreciate against most of the world's currencies. An appreciating US dollar combined with below trend growth in China and other EM economies is negative for commodity prices and for commodity exporting countries and their currencies. 

The questions one should ask about 2015 forecasts are these: 

• Can the macro divergences in the global economy be sustained without creating serious financial instability and in some countries and significant volatility in global currency and financial markets? 
• Can the low growth, highly-indebted Eurozone economies and Japan sustain stronger growth with super-accommodative monetary policy but without major economic reforms? 
• Can China navigate a soft landing of its over-leveraged economy?  
• Can Canada and Australia, with overheated housing markets, continue to grow at or above trend after a sharp fall in commodity prices and as the Fed begins to raise its policy rate? 
• Will we look back on 2015 as yet another year that started with optimistic forecasts and ended with disappointment? 

My tentative answers to these questions are: No, No, Don't Know, Unlikely, and Probably. As was the case last year, I suggest that investors should stay on their toes.

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.