With just two weeks left in an overly-long federal election campaign. Political leaders, economists and editorialists opine on a daily basis on the nature of the ills facing the Canadian economy and their chosen policy antidotes. Exaggerated claims about how minor policy changes will reinvigorate the Canadian economy and boost the wellbeing of the "middle class" are commonplace.
Canada recorded two consecutive quarters of modest declines real GDP in the first half of 2015. This added fuel to an inane "debate" over whether Canada is in a recession. In July, Bank of Canada Governor Stephen Poloz said this about the recession debate:
I just find the discussion quite unhelpful. It's especially unhelpful when what has happened to the economy is very narrowly defined.
Poloz said the discussion was "especially unhelpful" because the contraction was narrowly focussed on the oil and gas industry and suggested that "the fundamentals are positive and gathering pace in about 80% of the economy".
While I agree that the debate about recession is unhelpful, it for different reasons.
Canada is not experiencing a normal business cycle recession. It is experiencing a severe negative terms of trade shock.
The terms of trade refers to the price of Canada's exports relative to the price of our imports. A negative terms of trade shock occurs when a country's export prices fall relative to the prices of its imports. The terms of trade is of crucial importance to Canada, a medium sized economy that depends heavily on international trade for its growth and prosperity. In Canada's case, the terms of trade are subject to large swings. This is because a large proportion of our exports are commodity based -- oil and gas, metals and minerals, forest products and agricultural products -- and the prices of these commodities are more volatile than the prices of Canada's imports, which are predominantly finished manufacturing products -- motor vehicles, consumer goods and business machinery and equipment. In recent years, oil and gas exports have become increasingly important, accounting for 23% of Canada's goods exports in 1Q 2014, before the recent sharp decline in the price of crude oil. In total, commodity-based exports accounted for 51% of Canada's total exports.
The plunge in the world price of oil, along with weakness in prices of other commodities has dealt a severe blow to Canada's terms of trade. The chart below shows the strong link between the value (in current dollar terms) of Canada's commodity-based exports and the Bank of Canada's Commodity Price Index. Indeed, the link appears to have become even closer over the past 15 years as the development of Canada's oil sands added to its commodity exports.
The latest available data show that the Commodity Price Index was down 40% in 3Q15 from a year earlier. This implies a further significant decline in Canada's commodity-based export values, which were already down 13% from a year earlier in 2Q15.
While it is well understood that falling commodity prices hurt the value of Canada's commodity-related exports, what is less well understood is the direct effect that this has on Canada's Real Gross Domestic Income (GDI). Real GDI is total domestically-generated income, adjusted for inflation, of all sectors of the Canadian economy, including the household sector, the corporate sector and the government sector.
The chart below shows the tight relationship between the value of Canada's commodity-based exports and real GDI for the total economy.
Real GDI fell 1% from a year earlier in 2Q15. Based on the further decline in commodity prices in 3Q15 and the consequent likely further decline in commodity-based export values, real GDI growth is likely to have fallen further in 3Q15, even if real GDP growth turns positive. The only times that real GDI has fallen as sharply over the past four decades are during the 1981-82 recession, the 1991 recession, the bursting of the Tech Bubble in 2001, and the Great Recession of 2008-09.
Canada's prosperity is determined, not by real GDP which is a measure of the how much we produce, or by employment which is a measure of how many of us are working and how many hours we work, but by real GDI, a measure of the real value of the income we receive for the work that we do. The prices that we receive in world markets for the commodities that we extract, process and export are a primary determinant of real GDI growth. A terms of trade shock generated by a sharp fall in commodity prices can have just as negative an impact on Canada's prosperity as a deep business cycle recession, defined by sustained declines in production and employment.
What is also little understood is that a fall in the value of the Canadian dollar which accompanies a fall in commodity prices further erodes real GDI. As the currency weakens, the prices of imported goods, which are dominated by finished consumer goods and business machinery and equipment, rise in Canadian dollar terms. This exacerbates the drop in the terms of trade and increases downward pressure on real GDI.
This is also why BoC Governor Poloz's suggestion that the effects of the terms of trade shock are "narrowly defined" is misleading. When the price of oil and other commodities declines, the real income of oil producers in Alberta falls, but so does the purchasing power of consumers in Ontario, Quebec and other provinces, who must pay more for imported goods, services and foreign travel. The terms of trade shock is shared and spread across regions and industries by the fall in the value of the Canadian dollar. The real incomes of all Canadians suffer when the price of oil plunges and the Canadian dollar depreciates in value.
The problem for politicians and policymakers is that the negative terms of trade shock comes from outside Canada, not from changes in the behaviour of domestic consumers, corporations or governments. The current terms of trade shock has many causes, including the development of new technologies that have lowered the cost of producing oil; the decision by Saudi Arabia and other OPEC countries to continue to pump oil at a high rate rather than cut production to support the oil price; and the slowdown in China's economy which has lowered demand and prices for a broad range of commodities.
Whether or not the downturn in the global commodity super-cycle causes a business-cycle recession measured by GDP and employment is not the most important issue. The most important point to grasp is that Canada is facing a period in which the combined real income of households, corporations and governments are declining and are unlikely to rebound quickly. Even if real GDP resumes growing in the second half of 2015 and employment continues to rise, we will be producing and working more but receiving less real income for our efforts.
What the Economic Debate Should be About
The real economic issue that politicians should be facing is not whether Canada has slipped into a modest business cycle recession, but rather what is the appropriate economic policy response to a lasting negative shock to our national income caused by the fall in the prices of the commodities that we produce.
The Conservative Party wants to stay the course, keeping taxes low, encouraging home-ownership, and pursuing a balanced budget. That is a reasonable start, but does not go far enough in providing incentives to boost growth outside the resource industries.
The Liberal Party wants to raise taxes on high income earners including high-income small business owners, reshuffle child benefits to favour the "middle class", and incur deficits to fund infrastructure projects. The difficulty in this approach will be to maintain business confidence and to control deficit spending in an environment of weak GDI growth.
The New Democratic Party (NDP) wants to raise corporate taxes, impose carbon taxes, expand government's role in child care, and pursue a balanced budget. This is a difficult if not impossible set of promises to deliver on during a period of weak commodity prices.
The worst election outcome, but perhaps the most likely according to current polls, would be a coalition government of the NDP and Liberals. Coalition economic policies would likely result in higher taxes on high income earners, small businesses and corporations, increased spending on government provided child-care and infrastructure, and an early loss of control of budget deficits.
All three political parties and all Canadian voters would be well advised start thinking about what kind of pro-investment, pro-growth policies Canada needs to pursue in a period when the main economic engine and source of national prosperity has stalled and shifted into reverse.
Global ETF portfolios for Canadian investors turned in mixed performances in 3Q15. Equity-heavy portfolios incurred losses, while bond-heavy, risk balanced portfolios posted gains. Performance would have been much worse had it not been for the 6.2% depreciation of the Canadian dollar relative to the USD that increased C$ returns for Canadian investors in USD denominated global ETFs.
As in 2Q15, global economic developments were mixed but, once again, generally disappointing:
- The forecast for global real GDP growth in 2015 fell further in 3Q. Eight of the twelve large economies that I track saw downward revisions in their 2015 growth forecast. The US growth forecast edged up in 3Q after upward revisions to 2Q growth. However, real GDP growth forecasts for 2015 were revised down for the Eurozone, Japan, Canada, Australia, China, Korea, Brazil and Russia in 3Q15.
- Signs of weaker global growth, and particularly weaker Chinese growth, contributed to a fall back in crude oil prices following a modest recovery in 2Q15.
- Forecasts of 2015 inflation fell in nine out of the twelve countries in 3Q15 as oil prices fell back and deflation worries increased.
- China, Canada and Russia cut their policy rates in 3Q15, while Brazil was again forced to hike its policy rate in response to rising inflation and a weakening currency.
- Bond yields fell virtually everywhere in 3Q15, after rising virtually everywhere in 2Q15.
- China's equity market continued its' sharp correction that began in the final weeks of 2Q, falling by over xx% from its highs. The PBoC devalued the CNY sending shock waves through global markets.
- Emerging market turbulence, especially in China, combined with confusion over Fed policy added to worries about corporate earnings and triggered corrections in major global equity markets.
Despite below target inflation, the Fed continued to stress the need for "policy normalization". The window appeared to be open for a rate hike in September after growth rebounded in 2Q and employment gains remained strong through August. However, the Fed passed on the opportunity, apparently concerned that in light of China's growth slowdown and emerging market financial outflows, a Fed rate hike might further destabilize global financial markets. In the event, the non-action by the Fed appeared to exacerbate concerns of global growth slowdown, and sent equity markets into a further tailspin.
The Bank of Canada followed up on a January rate cut with a second 25 basis point easing in July, as it became increasingly apparent that the economy had suffered a second consecutive modest contraction in 2Q. The Canadian dollar, which had firmed versus the USD in 2Q on moderately higher crude oil prices, came under renewed downward pressure in 3Q as China's growth slowed and oil prices fell back.
Global Market ETFs: Performance for 3Q15
In 3Q15, with global growth and inflation expectations weakening, crude oil prices falling, and the USD appreciating by 6.6% against the CAD, the best global ETF returns for Canadian investors were in US government and investment grade corporate bonds. The worst returns were in commodities and Emerging Market equities. The chart below shows 3Q15 and year-to-date returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.
In CAD terms, 11 of 19 ETFs posted losses, while 8 posted gains. In local currency terms, only 3 of the 19 RTFs posted gains.
The best returns, in CAD terms, were in US Long Teasury Bonds (TLH) +10.6%; US Investment Grade bonds (LQD) +7.8%; non-US Developed Market bonds (BWX) +6.7%; and US Inflation-linked bonds (TIP) +5.6%.
The worst losses were in the commodity ETF (GSG), which returned -13.8% in CAD, and the Emerging Market equity ETF (EEM), which returned -11.8%.
All of the Canadian ETFs that we track posted losses in 3Q15, but Canadian bond ETFs outperformed Canadian equity ETFs. The Long Bond ETF (XLB) returned -0.3%; the Real Return bond (XRB) -0.6%; the Corporate bond (XCB) -0.8%; while Canadian equities (XIU) returned -6.8%.
Global ETF Portfolio Performance
In 3Q15, the global ETF portfolios tracked in this blog posted mixed returns in CAD terms, when USD currency exposure was left unhedged.
When USD exposure was hedged, the portfolios all posted negative returns. In a November post, we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.
The traditional Canadian 60% Equity/40% Bond ETF Portfolio lost 2.3% in CAD when USD exposure was left unhedged, but lost 5.2% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost 1.1% if unhedged, but lost 4.1% if USD hedged.
Risk balanced portfolios outperformed in 3Q15 if USD exposure was left unhedged. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 1.6% in CAD terms if USD-unhedged, but lost 5.0% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, gained 0.1% if USD-unhedged, but lost 4.6% if USD-hedged.
Despite their 3Q15 losses, all of the global ETF portfolios retained gains for the year-to-date in CAD terms if USD exposure was left unhedged. Year-to-date returns ranged from a high of 9.3% for the Levered Risk Balanced Portfolio to a low of 3.5% for the conservative 45/25/30 portfolio. If the portfolios were USD hedged, they all posted year-to-date losses, ranging from -3.0% for the 60/40 portfolio to -4.9% for the Levered Global Risk Balanced Portfolio. Interestingly, the Levered Global Risk Balanced Portfolio is the best year-to-date performer if USD unhedged, but the worst performer if USD hedged.
Recent Performance in Perspective
The mixed 3Q15 performance of the USD unhedged global ETF portfolios was driven by two factors: the fall in bond yields as global, and particularly Chinese growth, continued to slow; and the sharp weakening of the CAD versus USD as the Canadian economy contracted for two consecutive quarters, the Bank of Canada delivered another rate cut, and price of crude oil and other commodities fell.
Fed and BoC policy continue to tilt in opposite directions. US real GDP growth, while disappointing, is still expected to reach 2.5% in 2015, double that expected in Canada. However, weak September readings for the ISM manufacturing PMI and US nonfarm payrolls, suggest that the US economy is losing momentum again. While Canada's economic data has firmed so far in 3Q, the RBC manufacturing PMI showed a sharp contraction in September as the negative effects of lower crude oil prices continued to weigh on economic activity. While some Fed officials have resumed signalling a rate hike before year end, a US tightening this year is clearly in doubt. The BoC seems much more likely to cut rates again than to raise them over the next six months.
Three months ago, I said "As we enter 3Q15 in a continuing uncertain environment, characterized by sluggish global growth and divergent central bank policies, and with rich valuations for US equities, remaining well diversified with an ample cash position continues to be a prudent strategy." As 4Q15 begins, that still seems to be the scenario that is playing out.
The more conservative 45/25/30 portfolio (which I have favoured) was less volatile and incurred smaller losses in 3Q15 than the more aggressive 60/40 portfolio. The Risk Balanced portfolios outperformed because of their larger positions in government, corporate bonds and inflation-linked bonds. As we enter 4Q15, the environment remains uncertain, characterized by weak and divergent global growth and central bank policies. US equity valuations have become less stretched but are still expensive. Global recession risks are rising, not falling as expected by the consensus. Remaining well diversified with substantial US dollar exposure and an ample cash position continues to be a prudent strategy.
First, let me say that the Bank of Canada should get full marks for correctly anticipating the need to cut the policy rate to 0.75% in January and again to 0.50% in July. Many economists criticized the BoC for acting too soon and/or for surprising markets. But now, with the benefit of hindsight, it is clear that Governor Poloz and his colleagues provided timely and appropriate monetary easing.
While I have advocated rate cuts since early January and believe that additional easing may be needed, I think that the BoC should pause for now. I'll state my case by first reviewing the case for an additional rate cut now, then reviewing the case for standing pat, and finally by outlining some additional strategic considerations.
The Case For a September Policy Rate Cut
Economic data available through September 1 provide support for another rate cut.
Real GDP contracted modestly for a second consecutive quarter in 2Q15. This has touched off a lively debate in the financial pages over whether this meets the definition of a recession. Some say that, at least, Canada is in a "technical recession", which they define as two consecutive negative quarters of real GDP growth. But this is an arbitrary definition latched onto by the press because it is simple to understand. More sophisticated analysts use the National Bureau of Economic Research definition, which says that for a recession to be confirmed in the judgement of a panel of qualified business cycle economists, there must be "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales". So far, industrial production and real incomes have fallen while employment and sales have held up. It normally takes a year or more for a recession to be confirmed and it is far too soon to render such a judgement for Canada.
More important than whether the economy is in recession is the fact that, by the Bank of Canada's latest estimate, the output gap worsened to -2.2% at the end of 2Q15 from -1.1% at the end of 4Q14. The economy was twice as far away from the BoC's definition of full capacity at mid-year than it was when the year began. This is the most compelling rationale for the easing that has already occurred and possibly for the need for additional monetary ease.
Inflation, measured by the annual change in the CPI, averaged just 0.9% in 2Q15, before edging up to 1.3% in July. That is well below the Bank of Canada's 2% inflation target. Inflation expectations remain muted based on survey data and falling breakeven yields on real return bonds.
Commodity prices, after firming in 2Q15, have resumed the plunge that began a year ago in 3Q. As readers of this blog know, in my opinion this is one of the most important leading indicators for the Canadian economy. Canada is a small open economy. Commodity-based products make up a large proportion of Canada's exports, while finished consumer goods and business machinery and equipment make up a large proportion of Canada's imports. When commodity prices fall relative to prices of finished consumer goods and machinery and equipment, Canada suffers a reduction in its terms of trade. This has a direct negative impact on real national income.
The chart below shows that the Commodity Terms of Trade (CToT), which I define as the Bank of Canada's Commodity Price Index divided by the Core CPI, has renewed its' sharp decline and has fallen to a level below that seen at the depth of the 2008-09 Great Financial Crisis (GFC). The Canadian dollar has appropriately weakened along with the CToT to cushion the blow on the commodity producing industries. The weaker currency also spreads the effect of the CToT decline across the economy by reducing the real purchasing power of Canadian dollar incomes of consumers and businesses. This should also, over time, encourage a redeployment of resources out of the commodity-based sectors into now more internationally competitive manufacturing and tradable services. But this will take time.
For these reasons -- a widening output gap, low inflation and a further sharp decline in the Commodity ToT -- another rate cut by the Bank of Canada is easily defensible.
The Case Against a September Rate Cut
Although real GDP growth was negative in 2Q15, there were some bright spots in the economy. Total hours worked (the best measure of employment) grew at a 2.1% annual rate in 2Q after just 0.3% in 1Q. Retail and wholesale sales volumes rebounded to moderate growth after contracting in 1Q. Housing starts picked up after dropping sharply in 1Q. Real export volume edged up after dropping in the two previous quarters. Data through July show that 3Q was on track for a further gain in total hours worked, some improvement in manufacturing activity, and solid housing starts.
The Bank of Canada's measure of core inflation has moved up to 2.4% in July, from 2.3% in 2Q, and 2.2% in 1Q. This worries some economists. Core inflation is supposed to be a better guide to future inflation than the current total CPI inflation rate. But this is often not true for Canada, especially during sharp moves in commodity prices. When commodity prices fall sharply and the Canadian dollar weakens, prices of imported consumer goods rise in Canadian dollar terms even if they are stable in the currency of the exporting country. So as commodity prices have fallen, prices of many imported products in the Core CPI have been pushed up. This is the anomaly for Canada: when oil and other commodity prices fall, core CPI inflation is temporarily pushed up by the appropriately weakening Canadian dollar. When oil prices and the Canadian dollar stabilize, core inflation will come down. So the current 2.4% core CPI inflation rate is not a good guide to where inflation will be in the future. On the contrary, it is giving a misleading signal. Nevertheless, some economists have used the elevated level of the core CPI to argue against further easing of monetary policy.
For these reasons -- signs of some improvement in the economy in early 3Q data and an above-target core CPI inflation rate -- it is possible for some economists to recommend that the BoC should hold the policy rate at 0.50% in September.
Additional Strategic Considerations
In my opinion, the Bank of Canada should pause for now. This is not because I believe that the case for standing pat outlined above is stronger than the case for another cut. It is for the following reasons:
First, the economic impact of the financial market volatility seen in August -- especially the sharp drop in commodity markets and global equity markets led by China -- will not become clear until more data becomes available for 3Q15. One assumes that such volatility will tend to dampen global growth, particularly in commodity exporting economies and those with strong trade ties to China. However, the impact on advanced economies, including the US, Eurozone and Japan is not so clear, as these economies tend to benefit from lower commodity prices.
Second, Canada is in the midst of a federal election campaign with the vote scheduled for October 19. The incumbent Conservative party is in a three-way fight with the left-leaning New Democratic Party (NDP) and the Liberal Party. The three parties have quite different ideas about fiscal policy. The Conservatives favour pursuing a balanced budget, although they have in the past permitted the deficit to rise during periods of recession. The Liberals favour increased infrastructure spending and allowing budget deficits of "up to $10 billion" per year for at least two years to support the economy. The NDP favour increased spending on a national child-care program and greater support for municipalities funded by increased corporate and gasoline taxes. The NDP has had an early lead in opinion polls, although this may be shrinking. Nevertheless, the election outcome is highly uncertain and the eventual policy changes, if any, are unpredictable. Some observers, including myself, believe that a minority government led by the NDP or in some coalition with the Liberal Party, could have a substantial negative impact on business confidence and investment spending, not unlike what happened when the NDP formed governments in Ontario (1990-95) and British Columbia (1991-2001). This has the potential to further weaken the Canadian dollar and to prolong and deepen the current economic downturn.
Third, the Bank of Canada needs a game plan to deal with the possibility of a further weakening of the Canadian economy. Just one more 25 basis point policy rate cut will return the policy rate to its GFC low of 0.25%. This will not be enough easing to deal with a further weakening of the economy. The Bank needs to consider a wide range of options, including: moving to a zero or even negative policy rate; policy rate guidance that commits to holding the policy rate at an exceptionally low level for an extended period of time; and various forms of quantitative easing.
Conclusion
The Bank of Canada has performed its role of stabilizing inflation and economic activity admirably so far in 2015. In doing so, it has used a couple of its' few remaining bullets. At this stage, despite a strong case for additional easing, I believe that the Bank should hold its fire until after the federal election. By this time, it will be possible to judge the impact of the renewed plunge in commodity prices, the impact of recent financial volatility on global growth, and the likely future stance of fiscal policy.
Make no mistake about it. This is a challenging moment for the Canadian economy. What is not needed, is for the Bank of Canada to inject itself into the midst of the election campaign with a policy rate move that will inevitably become a political football.
Just a quick update to indicate that, in my opinion, the Bank of Canada's 25 basis point rate cut to 0.50% was quite appropriate.
I had recommended that the BoC cut to 0.50% as early as last March and again recently when the C.D. Howe Monetary Policy Council met last week.
Why do I think it was appropriate? To update the analysis from my recent post titled "Equilibrium Real Policy Rates: Does Anybody Really Know", the Taylor Rule for the appropriate policy rate, as cited recently by Fed Chair Janet Yellen is:
The current policy rate (R) should = the equilibrium real policy rate (RR*) + core inflation (π) + 0.5 * the gap between current inflation and target inflation (π - π*) + 0.5 * output gap (y).
Today's Monetary Policy Report provided the inputs required to calculate the appropriate policy rate. Using assumptions, along the lines of those used by Ms. Yellen, that the equilibrium real policy rate is close to 0% currently; that the underlying trend in inflation is assessed to be 1.5 to 1.7% (p. 15) and that the Canadian output gap is -2.2% (p. 20), the current policy rate should be 0.30% or (0 + 1.6 - 0.2 - 1.1), or slightly lower than the 0.5% that the Bank of Canada set today.
With the economy clearly in a marked slowdown and with a federal election looming in October, the Bank of Canada was wise to take out additional insurance to bolster the economy now. If growth recovers strongly later this year, the BoC may eventually be in a position to reverse the quite appropriate easing that has been provided since January.
Economic forecasting is easy. Anyone can fill in a spreadsheet with their best guesses of how GDP growth, inflation, and central bank policy rates will unfold and call it a forecast. There are no professional standards or guidelines that must be met to publish a forecast. An economist I once knew often said his goal in making forecasts was to be "100% memorable and 51% accurate".
Forecasting accurately is extremely difficult. This is partly because unexpected events or shocks are constantly buffeting economies. It is partly because economic data is published with some delay and is often significantly revised later, especially at cyclical turning points. This means that, at any point in time, even analysts who follow the economic data closely have an unclear picture of the current state of the economy which is the starting point for their forecasts. This makes it more difficult, even for the best analysts, to accurately foresee inflection points in growth and inflation.
As I have written elsewhere, another issue for forecasters is what is known as the "optimism bias". The optimism bias in economic forecasts is well documented and widespread. In a 2011 study for the US National Bureau of Economic Research, Jeffrey Frankel found that for 33 countries, on average, the upward bias in real GDP forecasts is 0.4% when looking one year ahead, 1.1% at the two-year horizon and 1.8% at three years. Despite Frankel's findings, forecasters retain their optimism bias. In recent years, this bias has had a seasonal component, with optimism seemingly peaking in December-January as year ahead forecasts are publicized. 2015 is proving no different.
The table below presents revisions in 2015 growth and inflation forecasts for the twelve economies that I regularly monitor in this blog.
Growth Forecast Revisions
The table compares forecasts made at the turn of the year with revised forecasts published last week by two of the very best global forecasting organizations, the International Monetary Fund (IMF) and JP Morgan Economics (JPM). For real GDP growth, there are substantial downward revisions across a wide range of countries. [Note that revisions to global growth are smaller, but this appears to be due to shifts in purchasing power parity (PPP) weights toward higher growth economies like China and India].
With all of the recent angst over Grexit and the bursting of China's stock market bubble, it is perhaps surprising that the largest downward growth revisions are not in Europe or Asia, but instead in the Western Hemisphere. The most significant downward revision is for the world's largest economy, the United States. The IMF has downgraded its' dizzying 3.6% forecast for US growth to 2.4%, while JPM has cut from 3.0% to 2.2%. The downgrade to US growth has cascaded through the hemisphere, with Mexico downgraded from robust to moderate growth, Canada downgraded from moderate growth to near-recession, and Brazil downgraded from virtually no growth to outright recession.
By comparison, growth downgrades are more moderate for Japan, the UK, Australia and Korea. There is a notable growth upgrades for India. Growth forecasts for the Eurozone and China are little changed, as is Russia's recession forecast.
This is where the optimism bias continues to rear its' head. Do forecasters really believe that the disappointments in Western Hemisphere are over and that the recent turmoil surrounding Greece and China will have no impact on Eurozone and Chinese growth? Could the turmoil be a harbinger of further problems within these large economies?
Inflation Forecast Revisions
Revisions to inflation forecasts are more mixed. The big change to factor into 2015 inflation forecasts has been the collapse in the price of crude oil over the past year. Most of the decline had occurred by early in 2015 and was being taken into account in turn of the year forecasts. These forecasts have been complicated by the effects of some large exchange rate movements.
On balance the largest downward revisions to end-2015 CPI inflation forecasts have been in the UK, Mexico, Australia and India. These downward revisions have been offset by large upward revisions to year-end inflation forecasts for Russia and Brazil, where exchange rate depreciation is pushing up inflation despite the economies being in recession.
There is no change in China's 2015 inflation forecast at 1.7%, despite inflation having averaged just 1.3% in the first six months of the year and despite clear signs that growth is slowing, that house prices are falling and that confidence has been shaken by the recent stock market crash.
Implications for Monetary Policy
The forecast revisions since the beginning of the year mainly reflect disappointment that overly optimistic growth forecasts have not been met. From a policy perspective, this has meant unexpected monetary policy easing in some countries and a delay in tightening policy in others. Among the economies monitored here, central banks of Canada, Australia, Korea, India and Russia have all provided policy rate cuts that were not expected at the beginning of the year, while Japan and the Eurozone have added to their QE bond purchase programs. The US and UK have delayed raising their policy rates.
Implications for Markets
In this environment of widespread downward revisions to growth forecasts, more moderate and mixed revisions to inflation forecasts and unexpected easing of monetary policy, asset markets have provided little gain and plenty of volatility. The chart below shows year-to-date ETF returns for the the major asset classes in both USD terms (green bars) and CAD terms (blue bars).
With the exception of Japanese equities (EWJ, which returned over 12%), USD returns on these ETFs have been weak, ranging from -8% for Canadian equities (XIU) to +4% for US Small Cap stocks (IWM). Of course, when a 9% appreciation of the USD vs CAD is factored in, Canadian dollar investors (who did not currency hedge) enjoyed positive returns on all of these ETFs.
Commodity returns were negative in USD terms. Eurozone (FEZ) and Emerging Market (EEM) equity returns were negative. Inflation-linked bond ETF returns were negative. Credit ETF (LQD and XCB) returns were negative in USD terms, with the exception of US High Yield (HYG). In Emerging Market bonds, those denominated in USD (EMB) had positive returns, but those denominated in local EM currencies had negative returns. US 10-year Treasury bonds (TLH) and non-US government bonds (BWX) also had negative returns in USD terms.
High Hopes Dashed, Uncertainty Remains
Hopes raised by the giddy economic forecasts made at the turn of the year have been dashed. Only those investors who played the currencies correctly have made any money this year; the underlying asset values have been eroded by disappointing growth, weak commodity prices, and fears that (sometimes desperate) monetary policy easing will be ineffective and/or ultimately reversed.
The biggest question mark for the remainder of the year is China. The bursting of the previously surging Chinese equity bubble has led the government to take unprecedented steps to stabilize the stock market that could yet backfire. A full-blown Chinese financial crisis would be devastating to still optimistic global growth and inflation forecasts.
Global ETF portfolios for Canadian investors gave back a lot of their first quarter gains in 2Q15. The weaker performance was partly attributable to a 1.6% appreciation of the Canadian dollar relative to the USD that reduced C$ returns for Canadian investors in USD denominated global ETFs.
Global economic developments were mixed but, once again, generally disappointing:
- The forecast for global growth in 2015 continued to be revised down.
- Global real GDP growth in 1Q15 fell to its weakest pace since the 2008-09 global recession. Four of the eleven large economies that I track contracted in 1Q15, including US, Canada, Brazil and Russia. The US is on track for a moderate growth rebound in 2Q15, but the other three economies are still contracting. Following decent starts to the year, Eurozone and Japan growth moderated in 2Q15.
- Crude oil prices stabilized and posted a modest recovery, supporting the currencies of oil exporting countries, including Canada.
- Inflation forecasts stabilized in 2Q15 as oil prices recovered and deflation worries eased.
- Despite the US Fed still signalling that it intends to begin raising the policy rate this year, global central banks continued to ease policy. China, Korea, Australia and Russia cut their policy rates in 2Q15. Brazil was again forced to hike policy rates to support its currency.
- After falling virtually everywhere in 1Q15, bond yields reversed course and rose virtually everywhere in 2Q.
- In the final weeks of 2Q, after surging into bubble territory, China's equity market entered a sharp correction, falling by over 20% from its highs.
- In the final days of 2Q, negotiations between Greece and its official creditors broke down and Greece defaulted on a 1.6 billion Euro payment to the IMF. As 3Q begins, with Greek banks closed, capital controls looming, and a referendum planned for July 6, the situation remains fluid.
Despite reduced growth prospects and below target inflation, the Fed continued to stress the need for "policy normalization". In late June, New York Fed President William Dudley said that a September rate hike is still very much in play. Importantly, the Fed continues to signal that the normalization of rates will be gradual and dependent on incoming economic data. This caution has taken some of the steam out of the US dollar appreciation.
The Bank of Canada failed to follow up on a January rate cut with additional easing, judging that the negative shock to growth and inflation from weaker crude oil prices was faster but not larger than anticipated. This judgement was challenged by the June 30 release of April real GDP data showing a fourth consecutive monthly decline and rekindling speculation that another easing move is needed. The Canadian dollar, which had firmed versus the USD on moderately higher crude oil prices, was weakening again as 2Q came to a close.
Global Market ETFs: Performance for 2Q15
In 2Q15, with crude oil prices recovering and the USD weakening 1.6% against the CAD, the best global ETF returns for Canadian investors were in commodity and Japanese equity ETFs. The worst returns, driven by rising bond yields, were in US government and investment grade corporate bonds and Eurozone equities. The chart below shows 2Q15 and year-to-date returns, including reinvested dividends, for the ETFs tracked in this blog, in CAD terms.
In CAD terms, 17 of 19 ETFs posted losses, while just 2 posted a gain.
The gains were in the commodity ETF (GSG), which returned 6.6%, and the Japanese equity ETF (EWJ), which returned 0.7% in CAD.
The worst losses were in US Investment Grade bonds (LQD) -5.6%; US 10-year Bonds (TLH) -5.1%; and the Eurozone equity ETF (FEZ) -5.1%.
Canadian ETFs performed poorly in 2Q15. The Long Bond ETF (XLB) returned -4.4%; the Real Return bond (XRB) -3.9%; the Corporate bond (XCB) -1.3%; and Canadian equities (XIU) -2.0%.
Global ETF Portfolio Performance
In 2Q15, the Canadian ETF portfolios tracked in this blog all posted negative returns in CAD terms when USD currency exposure was left unhedged. When USD exposure was hedged, the portfolios generated flat to modestly positive returns. In a November post, we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.
The traditional Canadian 60% Equity/40% Bond ETF Portfolio lost 2.3% in CAD when USD exposure was left unhedged, but just lost just 1.6% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost 1.8% if unhedged, but lost just 1.0% if USD hedged.
Risk balanced portfolios underperformed in 2Q15. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 4.2% in CAD terms if USD-unhedged, but lost just 2.5% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, lost 2.4% if USD-unhedged, but just 1.3% if USD-hedged.
Despite their 2Q15 losses, all of the global ETF portfolios retain decent gains for the year-to-date, ranging from a high of 7.4% for the Levered Risk Balanced Portfolio to a low of 4.3% for the conservative 45/25/30 portfolio.
Recent Performance in Perspective
The weak 2Q15 performance of the unhedged global ETF portfolios was been driven by two factors: the rise in bond yields as US economic data firmed and the Fed continued to tilt toward tightening; and the modest rebound of the CAD versus USD as the price of crude oil recovered. Both of these moves represented partial reversals of trends that generated strong 1Q15 returns (in CAD terms) for our global ETF portfolios. It is interesting question as to whether the 2Q15 reversals have run their course or will continue.
In its June Oil Market Report, the International Energy Agency noted that preliminary data indicate that crude oil inventory builds continued into the second quarter. Global supply and demand balances suggest that the pace of builds is not expected to slow until 3Q15 when supply growth is projected to be reined in. Crude oil inventories remain near record levels and oil production continues to run ahead of demand. The market also has been awaiting the outcome of the Iran nuclear negotiations ahead of a missed June 30 deadline that has now been extended. An agreement could put 1 million barrels of Iranian crude back on the market, but failure would spark renewed tensions.
Fed and BoC policy continue to tilt in opposite directions. In both countries, real GDP contracted in 1Q15. While US economic data has firmed in 2Q, Canada has continued to stumble as the negative effects of lower crude oil prices continue to weigh on economic activity. While the Fed has remained steadfast that policy rate normalization will begin later this year, the BoC has taken a wait-and-see approach since cutting its policy rate in January. The US economy remains better positioned than Canada for a 2H15 rebound and influential members of the FOMC continue to signal the possibility of a rate hike as soon as September.
Three months ago, I said "If growth disappoints in both countries as 2Q unfolds, however, it is likely that the Fed response will just be to delay tightening, while the BoC response will be to cut rates again." As 3Q15 begins, that seems to be the scenario that is playing out. For that reason, maintaining unhedged exposure to global ETFs remains my preferred portfolio stance.
The more conservative 45/25/30 portfolio (which I have favoured) incurred smaller losses in 2Q15 than the more aggressive 60/40 and Risk Balaced portfolios. As we enter 3Q15 in a continuing uncertain environment, characterized by sluggish global growth and divergent central bank policies, and with rich valuations for US equities, remaining well diversified with an ample cash position continues to be a prudent strategy.
While most market participants and strategists focus on when the first Fed tightening will happen, the more interesting question is where should policy rates be now and over the next few years. While it has made virtually no headlines, the debate on the "equilibrium real policy rate" has picked up in recent months. It is one of those debates which is impossible to win, but is very important to understand.
Ms. Yellen's View of the Equilibrium Real Policy Rate
My interest in the debate began with comments made by Fed Chair Janet Yellen in a speech on March 27, "Normalizing Monetary Policy: Prospects and Perspectives" (see here), which laid out the FOMC's views on policy rate normalization. In particular, Ms. Yellen argued that while the original Taylor Rule suggests that the Fed Funds rate should already be in the neighbourhood of 3%:
"Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero."
The Taylor Rule, as expressed by Ms. Yellen, is the following:
The current policy rate (R) should = the equilibrium real policy rate (RR*) + core inflation (π) + 0.5 * the gap between current inflation and target inflation (π - π*) + 0.5 * output gap (y).
Under the original Taylor Rule, the equilibrium real policy rate was assumed to equal 2% (roughly the average historical value of the real federal funds rate). With core inflation at about 1.25%, the inflation target assumed to be 2%, and the output gap close to zero (assuming full employment at the current US unemployment rate of 5.5%), the original Taylor rule calculation would indicate that the current policy rate (Fed Funds Rate) should be 2.875% (or 2% + 1.25% - 0.375% - 0%).
But Ms. Yellen argued that "more realistic" assumptions are that the equilibrium real policy rate is equal to 0% currently (as some statistical models suggest) and that the US output gap is -1%, based on the assumption that full employment is reached at 5% unemployment and the Okun's law calculation that y = -2* (U - U*). Hence, using the Yellen assumptions plugged into the Taylor Rule equation, the current policy rate should be 0.375% or (0 + 1.25 - 0.375 - 0.5). Indeed, using statistical model that she refers to (the Laubach-Williams model), which yields a most recent estimate of the equilibrium real policy rate of -0.165%, the Yellen estimate of the appropriate Fed Funds rate currently is 0.21%, or pretty much exactly where it is.
Why Has The Equilibrium Real Policy Rate Fallen?
A pioneer of the study of the equilibrium real policy rate is John C. Williams, the current president and CEO of the Federal Reserve Bank of San Francisco. Williams calls this the Natural Rate of Interest, which he defines as "the real federal funds rate consistent with the economy operating at its full potential once transitory shocks to aggregate supply or demand have abated". It is no surprise that Janet Yellen uses an almost identical definition of the equilibrium real policy rate as "the level of the short-term interest rate, less inflation, estimated to be consistent with maximum employment and stable inflation in the long run, assuming no future disturbances to the economy".
In a March 2 speech titled "The Decline in the Natural Rate of Interest" (see here), Williams laid out his estimates of how the natural rate, i.e. equilibrium real policy rate, has evolved and why it has declined sharply in recent years. The chart below shows how Williams' estimate of the natural rate has evolved.
In 1990, the equilibrium real policy rate was estimated to be 3.4%. By 2007, on the eve of the Great Financial Crisis, it had fallen to 2.1%. Following the crisis, it fell below 0% and has hovered there ever since, with the 4Q14 estimate at -0.2%.
The Williams-Laubach model estimates the equilibrium real policy rate as a function of the potential or trend real growth rate of the economy and other unspecified factors (which include demographics, fiscal policy, private sector leveraging or deleveraging, and technological change). In the 1990 to 2007 period, the model estimates that of the 1.3 percentage point drop in the equilibrium real policy rate, 0.5% was contributed by the decline in trend growth and 0.8% was contributed by other factors. In the 2007-14 period, the model estimates that of the 2.3 percentage point drop in the equilibrium real policy rate, half of the drop was contributed by the decline in trend growth and half by other factors.
What about Canada?
While there is no equivalent to the Williams-Laubach model for Canada, it seems clear that the same forces that Williams contends have lowered the US equilibrium real rate have also lowered that rate in Canada.
A February 2015 paper by Hamilton, Harris, Hatzius and West (HHHW, see here) provided data on real GDP growth rates and real policy rates for a wide range of developed economies.
Average real growth rates fell in all of the countries shown in the 2004-14 period compared with the previous ten year period. Similarly, average real policy rates fell in every country except Japan, where deflation resulted in a higher real policy rate. Based on their review of the cross country data, HHHW drew three conclusions:
- There is substantial uncertainty about the level the real equilibrium policy rate and its relationship with trend GDP growth is more tenuous than widely believed.
- Econometric analysis using cross-country data and going back to the 19th century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2%.
- The uncertainty around the equilibrium rate argues for more “inertial” monetary policy than implied by standard versions of the Taylor rule.
Given these cautionary conclusions, what might the Bank of Canada be thinking about the appropriate policy rate now and in the medium term future?
To attempt to answer this question, we can do the Janet Yellen type calculations for Canada. Since Ms. Yellen will be the Chair of the Fed from now through the medium term, we can assume that her thoughts on the US equilibrium real policy rate will be quite influential (as well as being supported by San Francisco Fed President Williams). Some statements from Bank of Canada Governor Poloz seem quite sympathetic to Ms. Yellen's assumptions and conclusions.
For Canada, using the original Taylor Rule, the equilibrium real policy rate is assumed to equal 2%. With core inflation judged by the Bank of Canada to be about 1.7% and the output gap calculated by conventional methods estimated to be -0.5%, the original Taylor rule calculation would indicate that the current policy rate (Fed Funds Rate) should be 3.4% (or 2% + 1.7% - 0.15% - 0.25%).
But using "more realistic" assumptions, along the lines of those used by Ms. Yellen, that the equilibrium real policy rate is close to 0% currently and that the Canadian output gap is -1.5%, the current policy rate should be 0.80% or (0 + 1.7 - 0.15 - 0.75), or pretty much exactly where it is.
Let's sum this up by saying that according to the original Taylor Rule, current policy rates in the US and Canada should be 2.875% and 3.4%, respectively. However, using the "more realistic" (or, if you like, "more dovish") assumptions that flow from the analysis of real equilibrium policy rates and larger estimates of the output gap, current policy rates in the US and Canada should be 0.2% and 0.8%, respectively, or pretty much exactly where they are.
Where will the Equilibrium Real Policy Rate Go Now?
In her March speech, Fed Chair Yellen expressed optimism that the equilibrium real Fed Funds rate will rise gradually as headwinds to growth diminish and the economy strengthens. Accordingly, if the equilibrium rate is rising over time, the "neutral" setting of monetary policy should be rising in tandem. She noted that FOMC members project that the equilibrium real Fed Funds rate will rise to 1.75% in the longer term, or 5-10 years from now. She concluded that,
Provided that inflation shows clear signs over time of moving up toward 2 percent in the context of continuing progress toward maximum employment, I therefore expect that a further tightening in monetary policy after the first increase in the federal funds rate will be warranted. Should incoming data, however, fail to support this forecast, then the actual path of policy will need to be adjusted appropriately.
Does Anybody Really Know?
My review of this debate convinces me of one thing. Central bankers do not have strong empirical foundations for determining the appropriate level of policy rate. Current low policy rates can be rationalized by assuming that the real equilibrium policy rate has fallen sharply and by assuming that our economies are still some distance below full employment. Some economists don't buy these assumptions. But neither side in the debate can prove that the other side is wrong.
As long as Yellen and Poloz remain at the helm of their respective central banks, low policy rates and very gradual rate normalization seem likely.
Does anybody really know what the equilibrium real policy rate is? Does anybody really care? (If you are exhausted after reading this, for some musical relaxation, see here .)
