Eight Miles High: A Note on Equity Valuations

In previous posts, I have commented that the equity market and other markets are overvalued because of the effect of large scale quantitative easing by the US Fed and other central banks. In this post, I will summarize several warnings from highly credible analysts about equity valuations that have been published in recent weeks.

When I think about US equity market valuation, I don't give much credence to the conventional Forward Price/Earnings (P/E) measure based on the current market price of the S&P500 divided by the 12-month forward projection of S&P500 earnings. Instead, I prefer to look at more credible historical metrics like the Cyclically Adjusted P/E (CAPE), originated by Nobel Prize winning economist Robert Shiller in his book Irrational Exuberance. CAPE compares the current price of the S&P500 with the 10-year average of S&P earnings with both variables adjusted for inflation. These measures tend to be mean reverting. The chart below, taken from Shiller's website (which can be seen here) shows the current valuation of the S&P500.

The current CAPE ratio, at 25.69 on August 15, suggests that only in the periods preceding the 1929 Crash and the 2000 Tech Bubble burst has the S&P500 been more richly valued. In those two periods and when the CAPE valuation reached close to current levels in 1901 and 1966, equity returns over the next 10 to 20 years were dismal.

Another advocate of credible long term valuation metrics is Andrew Smithers, author of Valuing Wall Street. Smithers favored metric is Tobin's q, (named after Nobel Prize winning economist James Tobin), which is calculated by dividing a company’s market capitalization by the replacement cost of its assets. Smithers has recently ended publication of his periodic market outlook reports, but not before publishing a final report on July 15 (see here). In his last regular look at market valuation, Smithers combines his historical estimate of q with his own technique of hindsight value to come up with the chart below.

Smithers notes that:

As at 31st March, when the S&P 500 was at 1872, the market was 80% overvalued and only on five previous occasions (1853 71%, 1906 62%, 1929 123%, 1968 66%, and 1999 152%) has the market been more than 50% overvalued. Market swings have been long. The gap between these 50% plus overvalued peaks has averaged 49 years but, with so few observations, there is no evidence to suggest that there is any regularity in the timing of peaks or troughs.

As I was doing the research for this post, I came across a new report written by Stephen Jones of String Advisors in New York, entitled, Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings and an Introduction of a Composite Valuation Model. The paper (here) examines the ability of CAPE and other metrics to forecast 10-year equity returns. One interesting finding is that a measure of equity market valuation favored by Warren Buffett, the ratio Market Value of corporate equity to GDP (MV/GDP), is a better predictor of 10-year forward returns than is CAPE. Bloomberg (here) published a chart of Buffet's favorite valuation metric, shown below.

The following chart shows comparisons on several metrics reviewed by Jones. By all of these metrics, stocks look expensive, but they look most expensive by the MV/GDP measure.

Jones goes on to argue that the market value-GDP ratio works even better at forecasting equity market returns in a multi-variable forecasting model which utilizes a demographic variable, a personal income to book value of US corporations variable, a personal consumption variable and a real GDP growth variable. This multi-variable or composite model, which Jones refers to as demographically adjusted and market adjusted (DAMA), has been a better predictor of 10-year stock market returns than any of the single ratio metrics discussed above. A comparison of the forecasts with actual results (the black line, which is only available through 1Q04) is shown below.

The forecast S&P500 levels 10 years forward (to 2024) and the annualized rate of return from each of the metrics and Jones composite model, are as follows:

• CAPE:        S&P500 at 2600, annualized return of 2.7%
• Tobin's q:   S&P500 at 2020, annualized return of 0.2%
• MV/GDP:   S&P500 at 1120, annualized return of -5.5%
• Composite: S&P500 at 650, annualized return of -10.5%

While some Wall Street commentators have criticized Shiller's CAPE (here), it is interesting that Tobin's q (Smithers favorite metric), Buffet's MV/GDP, and Jones' composite model (which has the best 10-year forward forecasting record) are all forecasting much weaker returns than Shiller's CAPE.

The point is that, starting from the current overvalued level of the S&P 500, all of the forecasts point to dismal returns for equities over the next decade. This does not mean that equities are about to crash or that stocks can't post decent gains over the next year or two. By most metrics, the S&P has not yet reached its valuation extremes of 1929 or 2000. Central banks continue to reassure that policy will remain accommodative. But the metrics do indicate that investor caution and alertness are warranted.

       

Global ETF Portfolios for Canadian Investors: July Review and Outlook

Global markets provided mixed returns in July amid heightening geopolitical risk and increasing concern that the US Fed and the Bank of England could raise policy rates sooner than previously expected. But for Canadian investors with unhedged portfolios of global ETFs, it was a highly profitable month. This was true because of the sharp depreciation of the Canadian dollar (CAD) versus the USD, which added to returns on foreign currency denominated ETFs in CAD terms.  

• Global equity market ETFs were mixed in July. Canadian, Emerging Market and Japanese equity ETFs posted gains, while Eurozone and US small-cap stocks were down. 
• Global bonds were also mixed, with Emerging Market bonds posting gains and Eurozone bonds posting losses in USD terms, but all bond ETFs showing solid gains in CAD terms. 
• Despite growing geopolitical risk emanating from Emerging Markets, EM assets were the strongest performers in July.
• Gold and commodity ETFs were among the biggest losers. 
• Energy prices weakened as the WTI crude oil futures price fell to $98/bbl at the end of July.
• The IMF further reduced its global growth forecasts for 2014 as did several central banks, but the US economy posted a stronger than expected 2Q rebound and economists remain upbeat on 2H14 US growth. 
• Global inflation showed mixed signals, with inflation firming in the US, UK and Canada, but weakening further in Europe.

On the central bank front, the Bank of England warned that markets were too sanguine about the timing of a BoE policy rate hike and then back-peddled, while the US Fed continued to taper its QE program but tried to reassure markets that it is in no hurry to raise its policy rate. Fed Chair Janet Yellen maintains that considerable slack remains in the labor market and is waiting for signs of stronger wage growth. Members of the FOMC remain divided on how soon and how much the policy rate should be raised. The ECB eased policy further but stopped short of outright Quantitative Easing. The BoJ remains committed to its massive QE program. Bank of Canada Governor Poloz continues to signal confidence in a soft-landing for Canada’s inflated housing market and no interest in tightening monetary policy any time soon.

Global Market ETFs: Monthly Performance for July

The S&P500 closed July at 1931, down from 1960 at the end of June. Global equity ETFs posted mixed returns in July. The C$ weakened 2.1% vs. USD in July, raising Canadian dollar returns on USD denominated ETFs. Emerging Market equities (EEM) provided the strongest returns among the equity ETFs we track, gaining 3.6% in CAD terms. Canadian equities returned 2.4%, while Japanese equities (EWJ) returned 1.8% in CAD terms. US Large Cap (SPY) fell 1.3% in USD terms but posted a positive return of 0.8%, in CAD terms. The worst performers were Eurozone equities (FEZ), which returned -3.8% in CAD terms, while US small caps (IWM) also posted a sizable loss, returning -2.5%.

Commodity ETFs lost ground in July. The Gold ETF (GLD) returned  -1.5% in CAD terms, while the GSCI commodity ETF (GSG) returned -3.6%.

Global bond ETFs posted solid returns in CAD terms, boosted by the strength of foreign currencies. ETFs with positive returns in July included USD-denominated Emerging Market bonds (EMB) and EM Local Currency Bonds (EMLC), which both returned 3.3% in CAD terms, the US long government bond (TLH), which returned 3.0%, and Canadian Long Government bonds (XLB), which posted a 1.1% return. Non-US government bonds (BWX) performed poorly, returning -0.9% in USD terms as peripheral European bonds weakened, but still managed a 1.3% gain in CAD terms.

North American inflation-linked bonds (ILBs) posted positive returns in July as inflation showed more signs of turning up. Canadian RRBs (XRB) returned 2.7%, while US TIPs (TIP) returned 3.3% in CAD terms. Non-US ILBs (WIP) returned 1.9%.

Corporate bonds underperformed government bonds in July as US investment grade (LQD) and high yield (HYG) bonds returned 3.0% and 1.5% respectively, in CAD terms. Canadian corporate bonds (XCB) returned 0.5%.

Year-to-date Performance through July

In the first seven months of 2014, with the Canadian dollar depreciating 2.5% against the US dollar, the best global ETF returns for Canadian investors were in Canadian equities (XIU), Canadian inflation linked bonds (XRB), and USD-denominated Emerging Market bonds. The worst returns were in US small cap equities (IWM).

In global equities, the Canadian equity ETF (XIU) performed best, returning 14.0% year-to-date (ytd). Emerging Market equities (EEM), which suffered early in the year from Fed tapering, political turmoil, and China’s growth slowdown, rebounded to return 8.3% ytd in CAD terms. The S&P500 ETF (SPY), which hit record highs in July before selling off sharply at the end of the month, returned 7.7% in CAD terms. The Japanese equity ETF (EWJ) returned 2.0%. The Eurozone equity ETF (FEZ), which had been the top performer through May, suffered from geopolitical tensions and currency weakness in June and July and has returned just 1.3% year-to-date (ytd) in CAD terms. US small caps (IWM), after another sharp selloff in July, returned just 0.7% ytd in CAD terms. 

Commodity ETFs had poor performance in July, dragging down year-to-date returns. The Gold ETF (GLD) has returned 8.9% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned 1.9%.  

Global Bond ETFs continued to perform extremely well for Canadian investors in the year-to-date through May. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, accommodative central bank policies and safe haven demand. The US long bond ETF (TLH) returned 11.4% ytd in CAD terms. USD-denominated Emerging Market bonds (EMB) returned an even more impressive 12.6%. The Canada Long Bond ETF (XLB) posted a gain of +9.2%. Emerging Market local currency bonds (EMLC) suffered from the same problems as EM equities earlier in the year, but rebounded to return 8.9% in CAD terms. Non-US global government bonds (BWX) posted a return of 7.6%. 

Inflation-linked bonds (ILBs) also turned in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) fared best, benefiting from its long duration, returning 12.7% ytd. Non-US ILBs (WIP) returned 9.8% in CAD terms, while US TIPs (TIP) returned 9.3%.

In corporate bonds, the US investment grade bond ETF (LQD) returned 9.5% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 6.8% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 4.3%.

Global ETF Portfolio Performance through July

In July, the Global ETF portfolios tracked in this blog posted surprisingly strong gains, adding to positive year-to-date returns, aided immensely by the weakness of the Canadian dollar.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 80 basis points in July to be up 7.5% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 111 bps in May to be up 6.8% ytd.

Risk balanced portfolios also posted robust gains in July. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 246 bps in July, boosting to its year-to-date gain to 13.3%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 165 bps in July to be up 8.7% ytd.

Outlook for August

The final week of July was a bad one with every ETF we follow declining in local currency terms. Conflict continued unabated in Gaza, East Ukraine, Syria and Iraq. Sanctions on Russia were intensified after the tragic downing of ML17. Argentina was declared in default on its foreign law bonds. The Fed continued to taper QE and tried to reassure markets that the policy rate would remain on hold for an extended period, but strong economic data convinced many that the Fed will have to signal a shift in policy before long. Inflation in the Eurozone fell to 0.4%, while the US Employment Cost Index rose faster than expected. After an extended period of sustained strength, global bond markets are uncertain and growing nervous about the timing of central bank tightening in the US and UK. 

Key developments that Canadian ETF investors should be watching in August include:

• US labor market developments will be a key focus because that is what Fed Chair Yellen is watching. A strong July employment report and evidence that wages are beginning to accelerate could extend the bond market sell-off.
• US dollar strength is being generated both by safe haven flows amid geopolitical turmoil and the divergence between renewed optimism on US growth and continued sluggish growth in key trading partners including the Eurozone, Japan and Canada. 
• Fallout from intensified Russian sanctions and the conflict in Gaza pose the most acute geopolitical risks, with neither Putin nor Netanyahu showing signs of willingness to back down.
• The Bank of Canada appears to be firmly on hold, content to let the Fed and the Bank of England to the lead in the next round of policy rate tightening. Further weakening of the Canadian dollar will be tolerated.
• US 2Q corporate earnings growth beat expectations (as usual), but the stronger labor market and faster wage growth desired by the Fed will squeeze margins unless demand also strengthens meaningfully. If it does not, equities will be in trouble in a rising interest rate environment.
• Concerns about global inflation are more balanced than earlier this year. Markets will carefully watch for signs of a continuing divergence between the Eurozone and US.
• Emerging markets ETFs rebounded strongly from weakness early in the year. Global asset allocation strategists encouraged investors to shift into EM assets, which had become relatively cheap. But with geopolitical risks concentrated in EM and the Fed ending QE in coming months, the outlook for EM assets remains uncertain, as demonstrated by the sell-off in the final week of July.

Last month, I concluded that, “Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.”

As it turned out, the unstable disequilibrium appears to shifting, at least in the short term, toward stronger growth, higher inflation in the US, UK and Canada, and less accommodative central banks in those countries. The hint of this shift damaged risk assets at the end of July and could be a portent of things to come. While the ample cash dampened July returns in my desired portfolio, it helped in the final week of the month and will help in August if the shift mentioned above gains momentum.

Inflation or Deflation: Revisiting the Scenarios

In a January post on Inflation or Deflation: Implications for Portfolios, I outlined three scenarios to illustrate three different inflation outcomes:

1.     Rising Inflation,

2.     The comfortable Consensus, and

3.     Slide toward Deflation.

I put together three scenario paths of US CPI inflation, shown in the chart below along with the actual outcome through mid-year.

The inspiration for that post was a research note by Russell Napier of CLSA written in November 2013 entitled “An ill wind”. In the note, Napier argued that falling export prices from Japan, China and Korea constitute an ill wind from the East that would continue to blow in 2014 risking further declines in inflation in the US, Eurozone and other DM economies.

The Consensus at the beginning of 2014 expected US inflation to continue to fall in 1Q14 but then to rise modestly to 1.6% in 4Q14. In the Rising Inflation scenario, stronger US growth against the backdrop of a reduced potential growth rate would result in a quick move up in inflation to 2.5% by yearend. In the Napier-type Deflation scenario, US inflation would continue to drop well below 1% by the end of 2014. The actual inflation outcome for the year through June, due out tomorrow at an expected 2.2%, is much higher than contemplated in any of the scenarios that seemed reasonable at the beginning of the year. 

Napier’s note got me thinking that preferred portfolio allocation in 2014 would be very different in the three scenarios. I argued in January that either upside surprises on inflation or a move toward deflation could have highly negative outcomes for portfolios. We are now in the midst of a sharp upside surprise on inflation, but all asset classes and portfolios continue to perform well. What gives?

Inflation Leading Indicators

Napier’s note drew attention to three leading indicators to keep an eye on to help gauge which direction inflation is likely to take: TIPS-implied inflation (using 5-year break-evens), copper prices, and corporate bond spreads. The charts below show the three scenarios and actual outcomes for Napier’s leading indicators through mid-year 2014. 

US TIPs Breakevens have closely tracked the consensus scenario despite actual inflation falling short of consensus in 1Q14 and then rising above consensus in 2Q14.

Copper prices tracked below consensus in 1Q14, but firmed in 2Q14.

Corporate bond spreads have closely tracked the consensus view.

Equity, Bond and Currency Markets

In January, I believed that markets would behave very differently in the three scenarios outlined above. I relied on Napier’s research and my own judgment of recent market correlations to come up with what I believed would be the likely outcomes for key equity (S&P500), bond (10-year US Treasury yield) and currency markets (the Canadian dollar exchange rate USDCAD), which are of particular importance to Canadian investors. The charts below trace out what I thought in January would be the likely paths of these key market indicators in the three different scenarios as well as the actual outcomes.

To summarize the scenarios and the actual outcomes:

The Consensus scenario expected that with a modest rise in inflation by the end of 2014, the S&P500 would post a decent gain of about 8% to close to 2000, the 10-year UST yield would rise to 3.75% and Canadian dollar would end 2014 little changed with USDCAD at 1.06.

The Inflation scenario, which saw a rise in US CPI inflation to 2.5% by the end of this year, would see the S&P500 falling 10% to 1660, the 10-year UST rising to 4.15% and the Canadian dollar strengthening with USDCAD falling to 1.02.

In the Deflation scenario, the S&P500 would likely face a drawdown of 25% at some point in 2014, while the 10-yr UST would fall back to 2.25% and the Canadian dollar would weaken sharply with USDCAD rising to 1.20.

The actual outcomes, year-to-date in 2014 have been that inflation has risen much faster than expected, the S&P500 is already close to reaching the year-end Consensus expectation at 1978, the 10-yr UST is tracking even below the path we assumed for the Deflation scenario at 2.53% and USDCAD, after weakening sharply early in 2014, is back close to the consensus track at 1.073.

Implications for Canadian ETF Portfolios

 

I argued in January that asset class returns would vary quite dramatically across the three scenarios. The chart below compares the expected Canadian dollar total returns on the major asset class ETFs under the Consensus scenario with the actual returns for the year to date.

What is evident from the chart is that while equities have generated good returns as the Consensus expected, bonds have dramatically outperformed expectations. This was perhaps not surprising in 1Q14 when inflation surprises were tilting toward the Deflation scenario, but it is very surprising that this strong bond performance has endured through mid-year, when the inflation surprises have tilted toward the rising Inflation scenario.

Given this set of ETF returns, how have different portfolio structures performed? The chart below shows actual returns for the four different portfolios that I regularly track.

The first thing to note is that all four of the portfolios have earned decent returns year-to-date. This is not surprising because all of the asset classes have turned in positive performances. The Levered Risk Balanced Portfolio has outperformed the other three portfolios by 200-350 basis points.

What seems strange is that based on the three scenarios, the Levered Risk Balanced Portfolio was expected in January to outperform the other portfolios only in the Deflation scenario. In that scenario it was expected that bond yields would fall and the levered bond positions in the portfolio would perform well. In both the Consensus and Rising Inflation scenarios, the Levered Risk Balanced Portfolio was expected to underperform the other three portfolios, mainly because of its heavier, leveraged allocation to fixed income.

Conclusions

In the January post, I noted that, “Looking at the three scenarios, one is struck by the continuing risks to investing in the post-financial-crisis environment, characterized by unconventional monetary policies that have encouraged investors to move into risky assets and led to rich valuations for equities, bonds and credit”.

At mid-year, one must ask: If the economy is veering toward the Rising Inflation scenario, why have 10-year US Treasury yields fallen, fuelling outperformance by the Levered Risk Balanced Portfolio? The likely reasons are: 

• US growth in 1H14 did not live up to Consensus expectations fueling complacency that the Fed will not move soon to head off rising inflation, 
• Eurozone inflation has dipped toward deflation, prompting the ECB to consider new unconventional monetary easing measures, and 
• Flaring geopolitical risks including the conflicts in Eastern Ukraine, Iraq and Gaza are supporting flight-to-safety buying of US Treasuries.

If one believes that US growth will accelerate, that current high level of geopolitical risk will diminish, and that the Rising Inflation scenario will prevail, my preference at mid-year would still be the conservative 45% Equity, 25% Bond, 30% Cash portfolio. The evolving, highly uncertain environment still argues for a cautious and flexible approach.

Canadian ETF Portfolios: 2Q Review and Outlook

The second quarter of 2014 saw modest positive gains for Canadian ETF portfolios after a first quarter that saw strong gains from unexpected sources. After a 3.9% depreciation of the Canadian dollar relative to the USD in 1Q that provided a strong tailwind and proved quite profitable for Canadian ETF investors, the currency reversed course and appreciated 3.4% in 2Q. The strength of CAD produced losses in a number of foreign currency denominated ETFs.

Economic signals released in 2Q were very mixed: 

• US and global growth were far weaker than expected in 1Q14 with the US economy contracting at a surprising 2.9% annual rate and the global economy expanding at 1.4%, the weakest quarter since the GFC.   
• In contrast, US employment gains and purchasing managers' indexes were consistent with solid growth.
• Emerging Markets showed mixed performance with growth in Russia and Brazil slowing markedly, but growth in India accelerating.
• US and global inflation, which was worrisomely low early in the year, turned higher as food and energy prices rose and core inflation edged up.

US and global growth forecasts for 2014 were marked down down sharply in 2Q. As we explained in December, optimistic economic forecasts made at the beginning of each year recently have been met with disappointment. This year is no different as the weak growth in 1Q now has economists forecasting lower growth this year than in in 2013, which itself was a disappointment.

Disappointing growth in the US and Japan and uncomfortably low inflation in the Eurozone have kept central bank policy and forward guidance accommodative. The US Fed has continued to taper its QE program but, despite strong employment gains and a faster than expected decline in the unemployment rate, Fed Chair Janet Yellen appears in no hurry to raise the policy rate. ECB President Draghi also took additional steps to ease monetary policy and the Bank of Japan remains committed to large scale QE to hit the 2% inflation target. The Bank of Canada continued to signal in 2Q that it is in no hurry to raise its policy rate. However, a larger than expected rise in CPI inflation to 2.3% in May raised market expectations that the BoC might tighten ahead of the Fed and contributed to CAD strength late in the quarter. 

Global Market ETFs: Performance for 2Q14

In 2Q, with the Canadian dollar appreciating 3.4% against the US dollar, the best global ETF returns for Canadian investors were in Canadian equities and bonds. The worst returns were in Eurozone equities, US small cap equities and US high-yield bonds.

In global equities, the Canadian equity ETF (XIU) performed best, returning 6.0% in 2Q and 12.0% year-to-date. The S&P500 ETF (SPY) returned 1.1% in CAD terms in 2Q and 6.3% ytd, while the Japan equity EFT (EWJ) returned 2.6% in 2Q and -0.5% ytd, and the Eurozone equity ETF (FEZ) returned -2.0% and 3.1% ytd. Emerging Market equities (EEM) returned 1.8% in CAD terms in 2Q and 3.8% ytd. US small caps (IWM) returned -1.4% in 2Q and 3.3% ytd, significantly underperforming large caps (SPY).

Commodity ETFs turned in weak performance in 2Q, hurt by the strength of the C$. The Gold ETF (GLD) returned just 0.03% in CAD terms in 2Q, but was still up an impressive 10.6% ytd. The iShares GSCI commodity ETF (GSG) returned -0.6% in 2Q, but gained 5.7% ytd.  

Global Bond ETFs also turned in mixed performances in 2Q. Foreign bond ETFs were hurt by currency weakness relative to the Canadian dollar but long duration bonds benefited from a combination of weaker than expected economic growth and safe haven demand. The Canada Long Bond ETF (XLB) posted a gain of 4.3% in 2Q and 7.9% ytd. The US long bond ETF (TLH) returned 3.0% in USD terms, but with the strengthening of the C$, this translated into a -0.5% return in CAD terms. Despite the 2Q loss, TLH was up 8.2% ytd based on strong 1Q performance. Non-US global government bonds (BWX) fared no better, posting a return of -0.7% in CAD terms in 2Q, but hanging on to a 6.2% return ytd.  USD-denominated Emerging Market bonds (EMB) returned 1.0% in CAD terms in 2Q and 9.0% ytd, while EM local currency bonds (EMLC) returned 0.5% in 2Q and 5.4% ytd. 

Inflation-linked bond (ILB) returns also varied according to their currency denomination. The Canadian real return bond ETF (XRB), benefiting from its long duration, returned 4.5% in 2Q and 9.8% ytd. US TIPs (TIP) fared worst returning -0.2% in CAD terms in 2Q and 5.8% ytd, while Non-US ILBs (WIP) fared a little better, returning +0.6% in 2Q and 7.6% ytd. 

Among corporate bonds, the Canadian corporate bond ETF (XCB) performed best returning 1.6% in 2Q and 3.7% ytd. The US investment grade bond ETF (LQD) returned -0.7% in CAD terms in 2Q but held on to a gain of 6.3% ytd. The US high yield bond ETF (HYG) posted a return of -1.3% in 2Q and 5.3% ytd as high yield spreads widened.

Global ETF Portfolio Performance for 2Q14

In 2Q14, the Canadian ETF portfolios tracked in this blog posted modest positive returns, following strong performances in 1Q.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 1.62% in 2Q basis points to be up 5.87% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 1.54% in 2Q to be up 5.34% ytd.

Risk balanced portfolios underperformed in 2Q. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 1.40% in 2Q, but had a stellar gain of 10.44% ytd. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 1.10% in 2Q to be up 6.8% ytd.

Outlook for 3Q14

Asset price gains slowed in 2Q and the Canadian dollar reversed most of its 1Q weakness. Year-to-date portfolio returns remained solid but momentum slowed markedly in 2Q. 

For the year-to-date, the strongest ETF returns in the portfolios tracked in this blog have come from Canadian equities, gold, Canadian inflation linked bonds, emerging market bonds and Canadian and US long bonds. Both gold and long bonds have far outperformed strategists expectations. This has come amid weak economic growth, geopolitical stress and low inflation. In 2Q, however, there were clear signs that some asset valuations had become stretched. US small cap equities, Eurozone equities, and US high yield debt all posted subdued gains in in USD terms and outright losses in CAD terms.

Most strategists now expect the surprises of the first half of 2014 to unwind. The consensus view is that US growth will rebound to a 3% or stronger pace, lifting global growth. Inflation is expected to creep higher. Yet the Fed, ECB and BoJ are expected to remain patient, delaying any tightening until mid-2015 or later. Just as the strongly held growth optimism at the beginning of 2014 went off the rails, the current consensus view seems likely to prove wrong. It is likely to prove wrong because it is internally inconsistent. If growth rallies strongly and inflation moves higher, it is unlikely that central banks will remain as accommodative as markets expect. On the other hand, if growth continues to undershoot expectations enabling central banks to remain easy, both equity and high yield debt valuations are likely to remain under pressure. 

In this uncertain environment, remaining well diversified with an ample cash position seems like the prudent strategy. High-yield debt positions should be trimmed. Long duration bond positions are at risk if the consensus view plays out. Equities and commodities would be at risk if growth fails to reaccelerate.    

Last month, I concluded that, “The twin risks remain: either stronger economic growth reverses the bond market rally or further disappointment on growth reverses the equity rally. Having ample cash in the portfolio was a prudent strategy in May and remains so in June.”

As it turned out, a number of major equity and bond markets lost momentum in June and Canadian portfolios with substantial cash positions outperformed portfolios with heavy exposures to global equities and bonds. Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.

Central Bank Communication: No Place To Stand

The following is a presentation that I made at the Canadian Economics Association Annual Meeting in Vancouver on May 31, 2014. The presentation was my opening comment on a panel discussion, sponsored by the Centre for International Governance Innovation (CIGI) and chaired by Paul Jenkins, former Senior Deputy Governor of the Bank of Canada. The topic for the panel was "Critical Challenges Facing Central Banks: Independence, Remit, and Communications". The other panelists were Paul Beaudry, Vancouver School of Economics, University of British Columbia; Douglas Laxton, International Monetary Fund; and Pierre Siklos, Wilfred Laurier University.

Good morning. It was a pleasant surprise when Paul Jenkins asked me to be on this panel. I have written a lot in my career about central bank behavior, especially that of the Bank of Canada.

I have done this from various vantage points:

First, as research director at the CD Howe Institute where I worked with Tom Courchene and Peter Howitt on their reviews of Canadian monetary policy in the 1980s.

Second, as Chief Canadian Economist for JP Morgan, where I worked with economists around the world to forecast global growth, inflation, interest rates and exchange rates.

Finally, as Managing Director of OMERS Global Macro Portfolio, where I headed up a team of strategists and traders whose objective was to invest in global stocks, bonds, commodities and currencies to achieve solid risk adjusted returns for the pension plan.

In all of these positions, it was important to understand the objectives and policy framework of central banks. At the CD Howe, my objective was to help provide policy analysis for public debate. At JP Morgan and OMERS, my objective was to apply that understanding to make money for clients or pensioners. 

After more than 30 years of watching monetary policy, I must say that today, I find it more challenging than ever. 

In this presentation, I will outline my views on the challenges facing central bank’s in establishing their remit, communicating their conduct of policy and protecting their independence.

I will illustrate my case with quotations from central bankers who have reflected on these issues over the past 35 years.

For a start, this quote is from a 1982 speech titled “A Place to Stand” by former BoC Governor Gerald Bouey near the end of his term which had been highlighted by the adoption of monetary targets.

Bouey said that the BoC adopted monetary targets in the hope that they would provide “a better place to stand against the constant pressures…for easier money and lower interest rates”.

In his speech, he outlined how financial innovation had caused instability in the demand for money with the result that monetary targets failed to provide a clear place to stand, from which the central bank could communicate how and why monetary policy actions were being taken and thereby maintain its independence. 

Before I get ahead of myself, I would like to explain how I understand, remit, communication and independence:

 

So let’s start with the remit, using the BoC as an example. The remit is the currently agreed upon interpretation of the BoC’s mandate which was laid out in the Bank of Canada Act of 1935.

As I read it, the original mandate tasked the BoC with three objectives:

• To regulate credit and currency;
• To control and protect the external value of the C$; and
• To mitigate fluctuations in output, trade, prices and employment. 

Gerald Bouey explained in his 1982 speech that, up to that time, the Bank of Canada’s interpretation of its remit had gone through three stages.

Since his speech, I would argue, there have been two more re-interpretations of the remit.

 

The Clean Doctrine was based upon a view presented by Fed Chairman Alan Greenspan at the Jackson Hole conference in 2002, which held that:

 

During Inflation Targeting I, the BoC contended that hitting the inflation target was the preeminent objective of monetary policy. As BoC Governor Thiessen said in 1997, achieving the inflation target was “the best contribution that monetary policy can make over time to a well-functioning economy – an economy that delivers growth in output and employment”.

Bank of Canada communication during Inflation Targeting I consistently hammered home this message. This quote from BoC Governor Gordon Thiessen was repeated in various forms in many speeches throughout his term and that of his successor, David Dodge.

 

Governor Dodge’s quote from a 2003 speech makes it crystal clear that the BoC agreed with the Clean Doctrine. The BoC saw its remit as using the policy rate to stabilize inflation around the target. It did not believe that it should target asset prices or attempt to lean against or pop asset bubbles. 

Another feature of BoC communication in the Inflation Targeting I era was the strong suggestion that the milder recessions and generally the reduced volatility of real output since the early 1990s – which came to be known as the Great Moderation – was, in large part, the result of the success of Inflation targeting in delivering low and stable inflation. This quote from a 2006 speech by BoC Deputy Governor David Longworth makes the point. 

David Longworth's quote is very similar to a statement made in a 2004 speech by then Fed Governor Ben Bernanke entitled “The Great Moderation”, in which Bernanke said, “improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation but to the reduced volatility of output as well… This conclusion on my part makes me optimistic for the future." (Ben Bernanke, “The Great Moderation”, February 20, 2004).

One year after Longworth’s speech came the Great Financial Crisis – the worst episode of financial and macroeconomic volatility since the Great Depression. 

Central Banks that had adopted Inflation Targeting and the Clean Doctrine were challenged to clean up the mess. Policy rates fell to the lower bound in many countries and central banks adopted unconventional instruments including quantitative easing, credit easing, and forward guidance.

This quote by BoC Governor Mark Carney highlighted the shortcomings of the Inflation Targeting I and the Clean Doctrine.  

Carney argues that low and stable inflation combined with central bank promises to mop up the mess can actually sow the seeds of powerful financial instability which can lead to instability of output and inflation. It appears that adopting the Clean Doctrine had fueled risk-taking behavior and exacerbated the crisis. 

In Canada, the Inflation Targeting remit of the BoC was due for review and renewal in 2011 and this ushered in the era of Inflation Targeting II. Some refer to this new remit as Flexible Inflation Targeting. The three key elements of the remit are shown in this slide.

 

The significant change is contained in the third bullet. It suggests that the goal of returning inflation to the target may occasionally be altered to support financial stability. It suggests that the BoC may decide to utilize the policy rate to lean against possible asset price bubbles, which might lengthen (or shorten) the projected time path of inflation back to the target level.

The difficulty with this change is that the BoC now has two stated goals – price stability and financial stability – but only one instrument, the policy rate.

What is equally worrisome, is that the validity of the analytical framework employed by the BoC to communicate and explain its decisions during the Inflation Targeting I era is increasingly in doubt.

 

The first quote below, from 2006 by Governor David Dodge, lays out the simple Aggregate Demand-Aggregate Supply framework that has been the centrepiece of BoC communication since the inception of inflation targeting.

The second quote from 2014, by outgoing Senior Deputy Governor Tiff Macklem raises serious doubt about the usefulness of the domestic AD-AS framework based on the output gap. Macklem’s speech pointed out that the dominant determinant of Canadian Total CPI Inflation is not the output gap but Total Global Inflation. Domestic factors are more important in determining Canadian Core CPI Inflation, but the coefficients on the determinants of core inflation are too small and statistically insignificant to be realistic guides to policy.

What are the implications for central bank independence? It is my contention that central bank independence is granted by the elected officials who form the government but that, once granted, independence must be continuously earned by successful execution of the central bank’s remit.

This chart from a paper by former Fed Vice-Chairman Donald Kohn shows US polling results on the public’s confidence in Fed. 

In 2007, before the GFC, over 50% of the public said they had a great deal or a fair amount of confidence in the Fed, while only 25% said they had only a little or almost no confidence. By 2012, almost four years into the recovery, just 39% said that they had a great deal or a fair amount of confidence, while 47% said that they had little or no confidence.

This explains why the Fed has been concerned about threats to its independence.

Ben Bernanke, speaking in Toronto in April 2014, made this quote:

 

Even though the Bernanke Fed must be given much credit for the steps it took during the GFC to avert a much bigger financial collapse, this quote is evidence that the consensus on the central bank remit, the clarity of the communication of monetary policy, and the independence of the Fed and other central banks have suffered.

I close with this slide.

Tinbergen’s Rule holds that consistent economic policy requires that the number of instruments equal the number of targets. More targets than instruments makes targets incompatible. More instruments than targets makes instruments alternative; that is, one instrument may be used instead of another or a combination of others.

Central Banks have been tasked with multiple objectives, not just price stability. They have innovated through the increased use of non-conventional instruments. In the process, they have not kept a clear identification of which instruments are to be used to pursue which targets. In addition, some of these instruments were never intended to be wielded independently by central banks, especially those involving private asset purchases and macro-prudential policies.

The world is much more complicated than it was widely believed to be during the Inflation Targeting I era. Like Gerald Bouey in 1982, I would conclude that unfortunately, inflation targeting has not provided the clear place to stand for which some had hoped.