Sunday, 28 December 2014

The Outlook for Global Growth in 2015

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

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

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

2015 Forecasts have Edged Down

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

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





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

2015 growth expected to be stronger almost everywhere

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

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


Once again: DM above trend, EM below trend

While global growth is expected to be a bit stronger in 2015, the divergence between DM and EM growth performance is expected to continue. EM growth is consistently higher than DM growth, but the important divergence is that DM economies are expected to grow above their trend (or potential) rate of growth, while EM economies are expected to grow below their trend rate. In the chart below, the blue bars show the 2015 growth forecast versus the OECD estimate of the trend growth rate for each economy.

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







Leading indicators support most growth forecasts

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

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

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


Conclusions and Questions

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

The questions one should ask about 2015 forecasts are these: 

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

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

Ted Carmichael is Founding Partner of Ted Carmichael Global Macro. Previously, he held positions as Chief Canadian Economist with JP Morgan Canada and Managing Director, Global Macro Portfolio, OMERS Capital Markets. 

Monday, 22 December 2014

Global Macro Misses: Biggest Forecast Errors of 2014

Economic and market forecasting is a mug's game. But that doesn't stop economists and strategists from making forecasts. At this time of year, I use a variety of sources to assemble a consensus view of economic and market outcomes for the year ahead. The turn of the year is always peak season for marketing investment themes based on year ahead forecasts. I'll review 2015 forecasts in a forthcoming post, but first, lets take a look back at 2014. In particular, let's look at the notable global macro misses and the biggest forecast errors of the year.

Real GDP


I have mentioned in previous posts that, since the Great Financial Crisis, forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2014. In the twelve major economies we track, real GDP growth fell short of forecasters' expectations in seven and exceeded expectations in just two countries. The weighted average forecast error was -0.3 percentage points.



Current estimates of real GDP growth for the two largest economies, the US and Eurozone, fell short of forecasts by 0.2 pct pts. The biggest misses were for  Brazil (-1.9 pct pts), Japan (-1.3), Russia (-1.2) and Mexico (-1.2). Canada and India beat forecasts by 0.3 pct pts and China by 0.1. On balance, it was a fourth consecutive year of global growth trailing expectations.

CPI Inflation


Inflation forecasts for 2014 were also too high. Six of the twelve economies are on track for lower than forecast inflation, while inflation will be higher than expected in five countries. The weighted average forecast error was -0.8 pct pts, a significant miss highlighting the disinflationary pressures that continue to dominate across the global economy. 



The biggest downside misses on inflation were in Emerging Asian economies including India (-3.4 pct pts), Korea (-1.9) and China (-1.7). These countries were joined by big DM economies including UK (-1.3), Eurozone (-0.9) and US (-0.4). The upside misses on inflation were in countries that experienced large currency depreciations, including Russia (+4.8), Brazil (+0.6) and Mexico (+0.4).

Policy Rates


Economists' forecasts of central bank policy rates were close to the mark for DM economies, but there were some notable misses for EM economies. In the DM, the ECB and the BoJ made small policy rate cuts that were not expected a year ago. 



The misses on central bank policy rates for there emerging economies were mixed. The biggest misses were for Russia, which is literally off the charts, at +11.5 percentage points, and Brazil at +2.3 pct pts, both economies where the currencies suffered sizeable depreciations. In emerging economies where inflation surprised to the downside and currencies were firm, the central banks cut their policy rates more than expected, as in Korea -0.50 pct pts and China -0.40.

10-year Bond Yields


In 10 of the 12 economies, 10-year bond yield forecasts made one year ago were too high. The deflationary forces at work in the Eurozone and China pulled 10-year yields down almost everywhere compared with forecasts of rising yields.



In all of the DM economies we track, 10-year bond yields surprised strategists to the downside. The weighted average forecast error was -1.10 percentage points. The biggest misses were in the Eurozone (-1.57), Australia (-1.54), UK (-1.37), Canada (-1.04) and US (-0.92). The only exception to the downside misses was Russia, which again was off the chart, with an upside surprise of 5.65 pct pts.

Exchange Rates


The strength of the US dollar surprised forecasters.  To be fair, the USD was expected to strengthen against most currencies, but not by nearly as much as it did. On a weighted average basis, the 11 currencies depreciated versus the USD by about 6.5% more than forecast a year ago.



The USD was expected to strengthen because many forecasters believed the Fed would begin to tighten by the end of 2014. While the Fed has been edging toward tightening this year, it has found various reasons to delay, with tightening now not expected to begin until mid to late 2015. If everything else had been as expected, this would have tended to weaken the USD. But everything else was far from as expected. The ECB, the BoJ, and even the PBoC eased monetary policy, something no economist forecast a year ago. On top of that, oil prices collapsed and other commodity prices weakened so that commodity currencies like RUB, MXN, CAD and AUD weakened more than forecast.

The biggest FX forecast miss was, not surprisingly, the RUB, which again was off the charts, more than 40 percentage points weaker than forecast a year ago. Other big misses were for MXN (-15.2 pct pts), BRL (-11.0), CAD (-10.6) and AUD (-8.6). GBP was the only currency that depreciated less than forecast versus the USD.


Investment Implications


The investment implications of the 2014 forecast misses were substantial. First, global nominal GDP growth was about a full percentage point weaker than expected, reflecting downside forecast errors on both global real GDP growth and global inflation. This would normally be bad for equity markets, but the weaker nominal GDP and profits growth was offset by easier than expected global monetary policy. US equities performed well in this environment, as did markets where central banks provided unexpected easing. Second, the downside misses on growth and inflation and the central banks' responses resulted in a strong positive returns on government bonds, the opposite of what the majority of strategists forecast. Third, divergences in growth, inflation and central bank responses, along with the sharp declines in crude oil and other commodity prices, led to much larger currency depreciations versus the USD than forecast. For Canadian investors, this meant that investments in both US equities and US government bonds, leaving the currency exposure unhedged, were big winners.










Thursday, 27 November 2014

Poloz Should Ignore the OECD

The Bank of Canada will make its final policy rate announcement of 2014 on December 3. No one expects BoC Governor Stephen Poloz and the Bank's Governing Council to make any change in the policy rate. It has been set at 1% since former BoC Governor Mark Carney completed a sequence of three 25 basis point rate hikes between May and September 2010.

It should be noted that none of the other major central banks -- the US Fed, the ECB, the Bank of England, or the Bank of Japan -- raised their policy rates at that time (although the ECB did make that mistake in 2011). Indeed, each of those central banks have further eased monetary policy, either by reducing their policy rate or by expanding their balance sheets through quantitative easing (QE) since 2010. It is as if, in the monetary policy race, the Bank of Canada made a false start and stopped, while the other central banks ran the other way!

Governor Poloz and his council do not make their decisions without considering what other central banks are doing. It cannot have escaped their attention that two of the major central banks, the BoJ and the ECB, are battling deflation pressures. The BoJ launched the most aggressive QE program to date in 2013 and just added another substantial dose at the end of October as it became clear that Japan had dipped back into recession. The ECB has introduced a negative deposit rate and promised to broaden its QE. The Fed ended its QE program in November and, along with the BoE made noises this summer about raising the policy rate in 2015. But with the recent drop in oil prices and general global inflation pressures, both Fed Chair Janet Yellen and BoE Governor Mark Carney have reassured markets that no early tightening is being contemplated.

But, OMG! Canada just reported that the total CPI inflation rate in October was 2.4% and the Core CPI inflation rate was 2.3%, both above the mid-point of the 1-3% target range.

Inflation hawks, like the economists at the OECD, are recommending that the BoC should begin another round of policy rate hikes within six months. Well, that would be a mistake!

Since the beginning of 2008, Canada's total CPI Inflation rate has averaged 1.64%, well below the mid-point of the 1-3% target band. Eighty percent of that time, the core CPI inflation rate has been below 2%. If the Bank of Canada had hit the 2% midpoint of the target range since 2008, the total CPI would be 2.1% higher than it is today. That means that over the past seven years, the CPI has fallen a full year behind the target.  

Recently, all major advanced economies have averaged growth well below their estimated potential. The chart below shows how much actual real GDP growth in the major economies has fallen short of the IMF's estimates of potential growth.


Since 2007, growth in Japan and Canada has fallen 3% short of potential, while the gap is -3.6% for the US, -4.8% for the UK and -6% for the Eurozone. Is it any wonder that the global economy is facing deflation pressures? As a consequence, most central banks remain focused on providing monetary accommodation or, at least, are reluctant to tighten policy.

Canada's monetary policy is already significantly tighter than those of the other major central banks. One way to see this is to look at current real policy rates, defined as the current policy rate minus the currently expected rate of inflation in 2015.


By this measure, the BoJ is the most aggressive central bank in fighting deflation (not even considering the impact of its massive QE program). The US Fed and the BoE remain highly accommodative. The ECB and BoC have the least stimulative real policy rates.

Canada's inflation rate has been pushed up temporarily by the recent depreciation of the Canadian dollar, which has pushed up prices of some imported goods including clothing. But there is still substantial slack in the economy. Gasoline prices have fallen and a likely to remain lower. The weakness in the Canadian dollar is an appropriate response the the drop in Canadian commodity prices and the weakening in Canada's terms of trade. A temporary rise of inflation is both a necessary and desirable consequence of the currency weakness for a country that has persistently undershot its inflation target for seven years.

Governor Poloz should ignore the OECD and resist the temptation to react to an upward blip in the inflation rate. He should follow the path taken recently by BoE Governor Carney, not the path taken in 2010 by then-BoC Governor Carney.    

Wednesday, 12 November 2014

Why We Are Not Currency Hedged

When constructing and managing their portfolios, all Canadian managers of global assets with foreign currency exposures must answer the question, "To hedge or not to hedge". Readers of this blog will have realized by now that we choose not to currency hedge the portfolios.

That does not mean that we ignore currency movements: We sometimes tilt our portfolio in favour or against more foreign currency exposure. It means that we have adopted a strategic policy not to hedge foreign currency exposure because we believe that in Canadian dollar denominated portfolios such exposure provides diversification benefits that largely offset the additional currency risk.

Over the past three years, adopting a no hedge strategy has been beneficial for Canadian investors in Global ETF portfolios, in terms of higher returns and with little or no increase in portfolio volatility. The chart below shows the growth of C$100 for the conventional 60/40 pension fund portfolio and for a Leveraged Risk Balanced portfolio. Returns are plotted for both the unhedged version and US dollar currency hedged version of each portfolio. 















These portfolios are constructed from the list of ETFs that we regularly monitor (see here). The ETFs for Canadian assets, such as the equity ETF (XIU), the long government Bond (XLB), corporate bond (XCB) and the Real return Bond (XRB) are denominated in Canadian dollars. The ETFs for US assets, such as the US equity ETF (SPY), the long government bond (TLH), and the inflation-linked bond (TIP) are denominated in US dollars. Commodity ETFs are also denominated in US dollars. The ETFs for non-US foreign assets, such as Eurozone equities (FEZ), non-US government bonds (BWX), Emerging Market equities (EEM), and Emerging Market local currency bonds (EMLC) are denominated in US dollars, but hold securities denominated in other currencies including the Euro, the Yen, a wide range of Emerging Market currencies. As a result, even though these ETFs are USD products, they do have exposure to a variety of other foreign currencies. 

The Hedged versions of the portfolios shown above assume that all of the foreign ETFs are US dollar hedged and therefore receive their US dollar return, while all of the Canadian ETFs receive their Canadian dollar return. The Unhedged versions of the portfolios assume that none of the foreign ETFs are hedged and therefore all ETFs receive a Canadian dollar return, which for the foreign ETFs will comprise the US dollar return plus the change of the US dollar versus the Canadian dollar.            

Comparing the two versions of the 60/40 portfolio, since the beginning of 2012, C$100 invested in the Unhedged version has grown to C$137.30 while the same C$100 invested in the Hedged version has grown to C$130.90. The Unhedged portfolio has had an annualized return of 11.6% over the period, compared with a 9.8% return for the Hedged version. This is not surprising as the US dollar has appreciated steadily over the period, so holding the ETFs in unhedged form in the portfolio has added returns. What is somewhat surprising, however, is that the volatility of the two portfolios has been almost identical.

Comparing the two versions of the Leveraged Risk Balanced (RB) portfolio, since the beginning of 2012, C$100 invested in the Unhedged version has grown to C$129.70 while the same C$100 invested in the Hedged version grew to only C$121.10. The Unhedged portfolio has had an annualized return of 9.4% over the period, compared with a 6.8% return for the Hedged version. The Unhedged Levered RB portfolio was about 15% more volatile than the Hedged version of the same portfolio. Interestingly, the Unhedged Levered RB portfolio was 40% more volatile that the Unhedged 60/40 portfolio over the period. 

During the recent period of Canadian dollar weakness, the "No Hedging" policy has boosted returns significantly. The chart below shows year-to-date returns in Canadian dollars for both the unhedged and the hedged versions of the four portfolios that we regularly track in this blog.



In 2014, leaving the portfolios unhedged has added from 300 to over 600 basis points to portfolio year-to-date returns. The largest positive effect has been for the Levered Risk balanced portfolio, because a substantial portion of the leverage is used for US dollar denominated government bonds. The Unlevered RB portfolio also has a relatively higher allocation to foreign currency ETFs than do the 60/40 and 45/25/30 portfolios.

In a future post, I will discuss the tactical adjustment to the Unhedged portfolios that may be taken to protect currency gains in the event that the Canadian dollar reverses course and begins to appreciate versus the US dollar.













Saturday, 1 November 2014

Global ETF Portfolios for Canadian Investors: October Review and Outlook

Most global markets recovered in the last three weeks of October from the sharp drawdown of the previous six weeks. Equity, commodity and credit markets continued to slide in early October with bonds rallying and recovering from their September losses. After a spike in volatility and sharp declines in global equity markets, the spark for recovery was a comment from St. Louis Fed President Bullard that the Fed should consider extending its bond purchasing program (QE) until inflation expectations show signs of stabilizing (for more, see here). The last three weeks of October saw a sharp rebound in equity markets, a modest rebound in credit markets and no rebound in commodity markets. 

Despite Bullard's musings, the Fed announced on October 29 that it was ending QE as planned and actually sounded a little more hawkish than anticipated. This may have been because the Fed knew that on October 30, US 3Q real GDP growth would be reported at a stronger than expected 3.5% annual rate. Then on October 31, the Bank of Japan provided a Hallowe'en treat by unexpectedly adding another large dose of QE stimulus.  

Significant market and global macro developments in October included:

  • The US dollar strengthened again versus major currencies, including a 0.6% gain against the Canadian dollar.
  • Energy prices weakened further as the WTI crude oil futures price fell to $81/bbl at the end of October down from $91/bbl at the end of September. 
  • Global equity ETFs were mixed. US small cap equities posted the strongest gains. Eurozone equities posted the largest losses. 
  • Global government bond ETFs, both nominal and inflation-linked, posted solid returns in October, despite giving up some gains in the final week of the month.
  • Gold and commodity ETFs posted further losses.
  • US GDP growth for 3Q was stronger than expected at 3.5%, while Canada is on a sluggish 3Q pace of just over 2%.
  • There were further signs of weakness in the Eurozone and China.    
  • Global disinflationary pressure continued to build as energy and other commodity prices fell. 
  • Central banks remain on divergent paths, with the US Fed ending QE and preparing markets for a policy rate hike in 2015; the BoE softening its stance an on early rate hike; the ECB continuing to ease policy with liquidity injections; and the BoJ significantly increasing its QE program by announcing additional purchases of JGBs, equities and REITs. The Bank of Canada dropped its forward guidance of being neutral as to whether its next policy move will be a tightening or an easing but Gover Poloz, worried about the impact of lower oil prices on Canadian growth, still shows no intention of tightening ahead of the Fed. 


Global Market ETFs: Monthly Performance for October

The S&P500 closed October at 2018, surpassing the previous record-high of 2011 reached in mid-September. Global equity ETFs were mixed in October, led by US Small Cap stocks (IWM) which rebounded a stunning 9.1% in CAD terms. Japanese equities (EWJ) gained 3.1% in CAD terms, with more than the entire gain coming on October 31 when the BoJ delivered its surprise easing. US Large Cap equities (SPY) gained 2.8% in CAD terms while Emerging Market equities (EEM) gained 2.1%. The worst performing equity market was the Eurozone (FEZ) which lost 3.0% in CAD terms. Canadian equites (XIU) lost 1.3% in October, reflecting declines in oil, gold and other commodity prices. 



Commodity ETFs posted further losses.  The Gold ETF (GLD) lost 2.4% in CAD terms, while the GSCI commodity ETF (GSG) was down 5.3%.

Global bond ETFs posted gains in CAD terms. The strongest returns in October (bolstered by the 0.6% appreciation of the USD versus CAD) were in USD-denominated Emerging Market bonds (EMB), which returned 2.6% in CAD terms, and US long government bonds (TLH), which returned 2.5% in CAD.  EM Local Currency Bonds (EMLC) returned 1.9%, Canadian Long Government bonds (XLB) posted a 1.2% return and Non-US government bonds (BWX) gained 0.4% in CAD terms.

Inflation-linked bonds (ILBs) also posted positive returns in October. US TIPs (TIP) gained 1.6% in CAD terms; Non-US ILBs (WIP) returned 1.0% and Canadian RRBs (XRB) returned 0.3%.

Corporate bonds provided solid returns in October. US investment grade (LQD) and high yield (HYG) bonds returned 1.9% and 1.7% respectively, in CAD terms, while Canadian corporate bonds (XCB) returned 0.8%.

Year-to-date Performance through October

In the first ten months of 2014, with the Canadian dollar depreciating 5.6% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in US long-term bonds (TLH), US large cap stocks (SPY), and USD-denominated Emerging Market bonds (EMB). The worst returns were in commodities (GSG) and Eurozone equities (FEZ). Canadian equities, which were the top performers through August, dropped back in year-to-date (ytd) performance as commodity prices fell again.

In global equities, the S&P500 ETF (SPY), returned 16.5% ytd in CAD terms, while US Small Cap stocks (IWM) returned 15.6%. The Canadian equity ETF (XIU) returned 11.2% ytd. Emerging Market equities (EEM), despite two rough spells this year, returned 7.7% ytd. The Japanese equity ETF (EWJ), after weakening in October, returned 6.0% ytd in CAD terms, with virtually all of its gain coming in a single day on October 31. The Eurozone equity ETF (FEZ), which had been the top performer through May, continued to suffer from geopolitical tensions, stagnant growth and EUR weakness and returned -1.7% ytd in CAD terms. 

After strong starts to the year, commodity ETFs have performed dismally in the second half. The Gold ETF (GLD) has returned 2.8% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned -8.4% ytd.  

Global Bond ETFs rebounded in October after their early September selloff. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, weakening commodity prices, safe haven demand and accommodative central bank policies. The US long bond ETF (TLH) returned 17.9% ytd in CAD terms, while USD-denominated Emerging Market bonds (EMB) returned 15.9% ytd. The Canada Long Bond ETF (XLB) posted a gain of 11.0% ytd. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 6.9% in CAD terms. Non-US global government bonds (BWX), also hurt by currency weakness, posted a return of 5.8% ytd.  

Inflation-linked bonds (ILBs) regained some lost ground in October and continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has benefitted from its long duration, returning 11.2% ytd. US TIPs (TIP) returned 10.4% in CAD terms, while Non-US ILBs (WIP) returned 8.6%.

In corporate bonds, the US investment grade bond ETF (LQD) returned 13.6% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 10.0% as high yield spreads have widened. The Canadian corporate bond ETF (XCB) returned 5.0%.

Global ETF Portfolio Performance through October

In October, the Global ETF portfolios tracked in this blog posted varying gains, reflecting their different asset mixes. Returns on all of the global ETF portfolios have been boosted substantially by the weakness of the Canadian dollar.



The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 79 basis points in October after losing 103 basis points in September and was up 9.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 103 bps in October after losing just 52 bps in September and was up 9.4% ytd, moving ahead of the 60/40 portfolio for the first time this year. The performance of the 45/25/30 Portfolio has validated our recent recommendation of holding ample cash. It has been the best performing portfolio since the end of August when the market correction began.

Risk balanced portfolios rebounded from their September losses and remained the best performers for the year to date. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 182 bps in October after losing 136 bps in September, and was up an impressive 16.1% ytd. 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, gained 148 bps in September after losing 71 bps in September to be up 11.1% ytd.

Outlook for November

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

  • US labor market developments remain a key focus. With its October 29 Statement, the Fed has begun to prepare markets for a normalization of the policy rate in 2015. US employment growth has averaged just under 250,000 per month since April and the unemployment rate has fallen to a cycle-low of 5.9%. Another strong report is expected on November 7 and with the timing of a Fed rate hike now clearly "data dependent" any significant surprise will set the tone for the post-QE3 era. 
  • Growth in Europe is stagnant and Germany has experienced a sharp drop in industrial production. German IP is expected to have seen a partial rebound in September when data is released on November 7. The day before, the ECB is expected to announce further monetary easing, but to stop short of sovereign bond purchases.
  • After the BoJ's surprising boost to monetary stimulus, markets will be watching for additional signs that the economy is rebounding from its sharp 2Q contraction that was induced by an increase in the consumption tax.  
  • Growth in China is weakening. The October manufacturing PMI was weaker than expected, falling back to 50.8 from 51.2 in September. A property slump and a slowdown in business investment has China on track in 2014 for its slowest growth since 1990 (for more, see here).
  • The divergence in growth trends and central bank policies has continued to push the USD higher against all currencies. This trend, while clearly justified, is likely to have significant consequences in the months ahead. First, it will dampen US import prices which along with lower oil prices will tend to depress US inflation pressures. Second, it will potentially weaken S&P500 earnings for those companies with significant foreign operations. Third, it will potentially reduce the need for early Fed tightening.  
  • The Bank of Canada has dropped its forward guidance that it was neutral on the direction of the next policy rate move. However, this does not mean that the BoC is in any greater hurry to raise its policy rate. Canada's real GDP is on track to undershoot the BoC's 3Q projection of 2.5% and BoC Governor has expressed concern about lower oil prices weakening Canada's growth prospects. Further weakening of the Canadian dollar will be tolerated.

     
Global disinflation/deflation concerns remain firmly in place. Weaker growth in the Eurozone, China, and other emerging economies, falling crude oil and corn prices, and the dampening effect of geopolitical tensions on consumer confidence all add to global disinflationary pressures. The risk of a global deflationary shock still seems much greater than the risk of a sharp increase in inflation.

In recent monthly reviews, I have 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.” In mid-October, as the market correction reached its nadir, some of that cash was put to work in US high yield bonds and some was put to work in Canadian high-dividend equities. Government bonds only look attractive if deflationary forces continue to mount. US equities, having rebounded to record highs, still look expensive. Consequently, maintaining ample cash in portfolios continues to look like the prudent approach.

Thursday, 23 October 2014

Equities Rebound: Is It Safe?

This post asks the question: "With global equities rallying back, "Is It Safe?" to take an aggressive position in risk assets. To set the mood, you might (or might not) want to watch this clip of Dustin Hoffman and Laurence Olivier in the movie Marathon Man.



In the last few posts, I have been writing about the sell-off in asset markets that began after Fed Governor Janet Yellen spoke at the Jackson Hole conference at the end of August. Yellen's speech was balanced and this spooked markets into thinking that the Fed might tighten sooner than expected. I referred to this concern as "Exit Ennui" and compared it with the selloff in asset markets that occurred in the May 2013, the so-called "Taper Tantrum". Bonds, commodities, high yield credit, EM equities and US small cap stocks all sold off over the first three weeks of September, while US and other DM stock markets held up well. However, in mid-September, signs of slower global growth, including falling crude oil prices, caused the sell-off that started with Fed tightening concerns to shift to global equity markets and a sharp correction followed. Commodities continued to sell off but bonds rallied back, with the 10-year US Treasury yield falling to 2.15%, its lowest since prior to the Taper Tantrum. 

The low point for equities was reached on October 16. On that day, equity markets turned higher when St. Louis Fed President James Bullard suggested that the Fed should consider extending QE, "to make sure inflation and inflation expectations remain near our target". The Bank of England's Chief Economist followed the next day with a suggestion that weak global growth should perhaps keep the Bank of England from raising its policy rate for an indefinite period. Since then, equities have roared back and bonds have given back some of their gains. 

The chart below, using weekly closes, shows the maximum drawdowns since August 29 (in Canadian dollar terms) for the ETFs regularly tracked in this blog and their subsequent rebounds.



The largest declines were in Canadian equities (XIU), commodities (GSG), Eurozone equities (FEZ) and Emerging Market Equities (EEM). Gold (GLD), US small cap equities (IWM) and Japanese equities (EWJ) also saw large drawdowns. In fixed income ETFs, the largest drawdowns, which occurred in the first three weeks of September, were in Canadian inflation linked bonds (XRB), Canadian Long Bonds (XLB) and non-US Developed Market government bonds (BWX). Corporate bonds had the smallest drawdowns.

What about the rebound? Which assets have performed best? The strongest rebound has been in US small cap equities (IWM), followed by US long Treasury bonds (TLH). Both of these ETFs have more than recovered from their drawdowns. 

Which assets have lagged in the rebound? Commodities have continued to flounder, not yet having found a bottom, although there were tentative signs of a rebound this week. With commodities not rebounding, Candian equities (XIU) and Emerging Market equities (EEM) have lagged other equity ETF rebounds. In fixed income, US long Treasury bonds (TLH) and US investment grade corporate bonds (LQD) have led the rebound, while emerging market local currency bonds (EMLC) have lagged.

While the Exit Ennui drawdown has been the biggest correction of 2014, the "buy the dip" mentality is clearly alive and well. The portfolios we track hit their weekly lows on October 10. With Bullard's help they have rallied back, but all remain lower than their August 29 levels. 



The question now is: with equities having rallied back, "Is it Safe?" to take a more aggressive position on risk assets. The answer is probably yes, but still with great caution.

Equities are still overvalued by reliable metrics, although a bit less so than at the end of August. Q3 earnings reports are coming somewhat mixed, but do not yet show signs of any surprising weakness. 

Bonds, which were already overvalued in late August, are now more overvalued and are at risk of giving back their recent sharp price gains if US economic data remain on the strong side. 

What investors need to be wary of is a series of bond sell-offs which trigger equity sell-offs. This would be the reverse of the pattern witnessed throughout the period of increasingly accommodative monetary policy as measured by the growth of the balance sheets of the US Fed and other major central banks.

While Mr. Bullard may have turned around the equity correction for now, Dallas Fed President Richard Fisher voiced the opposing view that. Despite the equity sell-off, the Fed should not delay its exit from QE. Fisher said:
"We've been floating this market with the Ritalin of easy monetary policy… indiscriminate investing took place ... all boats rose regardless of underlying value... People will actually have to do work ... have to understand analysis in order to make good investments."
So, "Is it Safe?" If the Marathon Man doesn't know, who does? 
 




Thursday, 9 October 2014

Oscillate Wildly: The Drawdown So Far

Oscillate Wildly is a catchy instrumental by The Smiths that you might want to listen to in an effort to calm yourself as market volatility ratchets up. In a post back on May 16 that I dubbed Comfortably Numb (after the Pink Floyd song), I noted that volatility across all asset classes had been low and falling for months and that investors risked being lulled into complacency by huge central bank liquidity injections. 

I said in May that the period of suppressed volatility could end either:

  • when stronger than expected US and global growth caused a spike in bond volatility and bond yields, or 
  • when weaker than expected growth caused a spike in equity volatility and a sharp correction in overvalued equity markets.
I suggested that since it was difficult to determine which of these scenarios would play out, that the prudent course of action was to trim risk exposures across all asset classes and temporarily move into cash. This seemed a good choice because, as I noted, "When the inevitable rise in volatility occurs, it will be possible for the investor to analyze which scenario is playing out and, once it has run its course, where to put the cash back to work". 

The recent spike in equity volatility and sell-off in global equity markets is not a straightforward case. It began after Fed Chair Janet Yellen gave a balanced speech at Jackson Hole that noted the strengthening of US growth and progress toward reducing labor market slack. The speech spooked markets into thinking that the Fed might hike rates sooner than expected. Bond volatility rose as bonds sold off, while equities hung in relatively well through mid-September. But as September gave way to October, market concerns shifted to the weakness of global growth, especially in the Eurozone and to the continuing drop in commodity prices. As growth concerns gained the upper hand equity volatility spiked and global equity markets sold off sharply. 

In a September post entitled Exit Ennui, I compared the current selloff across asset markets with the selloff witnessed in the spring of 2013 associated with the Taper Tantrum. It's interesting to update that comparison today, after a particularly bad day for global equity markets.

The two episodes had several things in common. Both were triggered initially by concerns about a shift to less accommodative US monetary policy. Both saw declines across all asset classes, as illustrated in this chart which shows local currency returns on the ETFs tracked regularly in this blog.



The drawdown in equities in the Exit Ennui selloff through October 8 is similar or worse than in the Taper Tantrum. The S&P500 ETF (SPY) has suffered a similar loss. Other DM equity markets, including Canada (XIU), Eurozone (FEZ), Japan (EWJ) and US Small Cap (IWM) have suffered worse losses than in the Taper Tantrum. The commodity ETF (GSG) has also experienced a much sharper loss, reflecting the downside surprises on global growth.

Fixed income ETFs, which fared poorly through mid-September have rallied back as global equities sold off. US and Canadian long bond ETFs (TLH and XLB) are back to close to flat since the beginning of the selloff. Inflation linked bond ETFs have sold off much less than in the Taper Tantrum, as have Emerging Market bond ETFs (EMB and EMLC) and corporate bond ETFs (XCB, LQD and HYG).

The movements in these ETFs tells me that what started out as an early Fed tightening scare has morphed into a global growth scare. Markets are pushing back expectations of when the Fed will begin to raise rates once again.

For Canadian investors in global ETFs, the pain of the selloff has been mitigated somewhat by the coincident weakening of the Canadian dollar. In the Exit Ennui selloff, the C$ has weakened 2.8% vs. the US$, more than double the 1.3% it weakened during the Taper Tantrum. This has meant that the drawdown triggered by Exit Ennui is taking a different shape from that of the Taper Tantrum as shown in this chart of ETF returns in Canadian dollars.






The chart clearly shows that in the Exit Ennui drawdown, which began with a selloff in bond markets, the best place for Canadian investors to hide has been US dollar denominated bonds.

As a result, risk balanced portfolios have performed better than a conventional 60/40 portfolio in the Exit Ennui drawdown. 


It is still too early to draw a conclusion about the current drawdown and to redeploy cash. The main question that needs to be answered is whether the slowdown that is engulfing Europe, Japan and many of the emerging markets will spread to the US, UK and Canada. If so, US and global equities have considerably more downside. If not, and growth in these countries proves resilient, equities may stabilize, but bonds could come under renewed pressure. Those who took the prudent advice can sit tight and listen to Oscillate Wildly.   






Wednesday, 1 October 2014

Global ETF Portfolios for Canadian Investors: Review and Outlook

Global markets pulled back in September. The month divided into two parts. The first three weeks saw US bonds selling off and the S&P500 holding its ground as markets priced in the possibility that Fed tightening might begin earlier in 2015 than previously anticipated. The last seven trading days of the month, saw a different dynamic, characterized by global growth concerns. Bonds recovered some ground, but equities sold off at the end of the month. For Canadian investors with currency-unhedged portfolios of global ETFs, losses were mitigated by another sharp weakening of the Canadian dollar.  Significant market and global macro developments in September included:
  • Every ETF we track in this blog lost ground in September in local currency terms.
  • The US dollar strengthened against most major currencies, including a 3% monthly gain against the Canadian dollar. 
  • Global equity ETFs were weaker across all major markets. The bigger losses were in Emerging Markets, US small cap, and Canadian equities. 
  • Global government bond ETFs posted mixed returns, with long duration US and Canadian bond ETFs posting the best returns and Emerging Market Local Currency bonds posting the worst returns.
  • Gold and commodity ETFs posted further sharp losses. 
  • Energy prices weakened further as the WTI crude oil futures price fell to $91/bbl at the end of September.
  • US GDP growth for 2Q was revised up to 4.6%, but growth stalled in Europe and showed further signs of weakening in China.    
  • Global inflation moderated in August as energy and corn prices fell. Eurozone inflation remained stuck at 0.3%. 
  • Central banks continue to be on divergent paths, with the US Fed and BoE preparing markets for policy rate hikes within six to nine months while the ECB and BoJ remain under pressure to increase stimulus. The Bank of Canada remains neutral as to whether its next policy move will be a tightening or an easing and seems to be clearly signalling that it has no intention of tightening ahead of the Fed. 

Global Market ETFs: Monthly Performance for September

The S&P500 closed September at 1972, down from a record-high of 2003 at the end of August, but was still up modestly from 1960 at the end of June. Global equity ETFs were uniformly lower in September. For Canadian investors with unhedged foreign equity exposures, however, the weakening of CAD turned some of these losses into gains. US Large Cap stocks (SPY) lost 1.8% in USD terms, but gained 1.1% in CAD terms. Japanese equities (EWJ) lost 0.3% in USD, but gained 2.6% in CAD terms. Eurozone equities wee down 2.8% in USD but flat in CAD terms. Other equity ETF losses were too large to be offset by currency movements. Canadian equites (XIU) lost 4.0%, while US small cap stocks and Emerging Market equities (EEM) lost 1.4% and 5.0% respectively in CAD terms. 



Commodity ETFs posted further sizeable losses.  The Gold ETF (GLD) returned -3.5% in CAD terms, while the GSCI commodity ETF (GSG) returned -3.3%.

Global bond ETFs posted mixed returns in CAD terms. ETFs with positive returns in September included the US long government bond (TLH), which was down 1.3% in USD but returned 1.6% in CAD, and USD-denominated Emerging Market bonds (EMB) which returned 0.7% in CAD terms. ETFs with negative returns included Canadian Long Government bonds (XLB), which posted a -1.7% return, EM Local Currency Bonds (EMLC), which returned -1.7% and Non-US government bonds (BWX) which lost 1.5% in CAD terms.

Inflation-linked bonds (ILBs) also posted losses in September. US TIPs (TIP) lost 2.6% in USD terms, but gained 0.3% in CAD terms. Canadian RRBs (XRB) returned -2.3%, while Non-US ILBs (WIP) returned -2.7% in CAD terms.

Corporate bonds were also mixed in September. US investment grade (LQD) and high yield (HYG) bonds lost ground in USD but returned 1.2% and 0.9% respectively, in CAD terms. Canadian corporate bonds (XCB) returned -1.0%.

Year-to-date Performance through September

In the first nine months of 2014, with the Canadian dollar depreciating 4.6% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in US long-term bonds (TLH), US large cap stocks (SPY) and USD-denominated Emerging Market bonds (EMB). The worst returns were in commodities (GSG) and Eurozone equities (FEZ). Canadian equities, which were the top performers through August, finally succumbed to weak commodity prices in September.




In global equities, the S&P500 ETF (SPY), returned 13.3% year-to-date (ytd) in CAD terms. The Canadian equity ETF (XIU) returned 11.9% ytd. US small caps (IWM), returned 6.0% ytd in CAD terms. Emerging Market equities (EEM), after a rough September, returned 5.5% ytd in CAD terms. The Japanese equity ETF (EWJ), after rebounding in September, returned 2.8% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, continued to suffer from geopolitical tensions and EUR weakness and returned 1.3% ytd in CAD terms. 

Commodity ETFs had lackluster performances this summer after strong starts to the year, dragging down year-to-date returns. The Gold ETF (GLD) has returned 5.4% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned -3.2%.  

Global Bond ETFs lost some of their lustre in September. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, weakening commodity pricessafe haven demand and accommodative central bank policies. The US long bond ETF (TLH) returned 15.1% ytd in CAD terms. USD-denominated Emerging Market bonds (EMB) returned 12.9% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of 9.7% ytd. Non-US global government bonds (BWX) posted a return of 5.4% ytd. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 5.2% in CAD terms. 

Inflation-linked bonds (ILBs) weakened in September but continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has benefitted from its long duration, returning 10.9% ytd. US TIPs (TIP) returned 8.7% in CAD terms, while Non-US ILBs (WIP) returned 7.5% in CAD terms.

In corporate bonds, the US investment grade bond ETF (LQD) returned 11.5% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 8.1% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 4.1%.


Global ETF Portfolio Performance through September

In September, the Global ETF portfolios tracked in this blog posted losses, trimming their year-to-date gains, which have been boosted substantially by the weakness of the Canadian dollar.



The traditional Canadian 60% Equity/40% Bond ETF Portfolio lost 103 basis points in September to be up 8.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost just 52 bps to be up 8.1% ytd.

Risk balanced portfolios also posted losses. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 136 bps in September, but was still up an impressive 13.9% ytd. 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 71 bps in August to be up 9.4% ytd.

Outlook for October

Key developments that Canadian ETF investors should be watching in October include:
  • US labor market developments remain a key focus. FOMC members have begun to prepare markets for increases in the Fed Funds rate in 2015. QE is ending and a "normalization" of the policy rate is expected to follow. I wrote about "Exit Ennui" in mid-September (see here). While US employment growth remains relatively strong and US real GDP growth remains solid, growth in Europe is stagnant and growth in China appears to be weakening. This is likely to create tension within the FOMC as hawks focus on US relative strength while doves give more weight to moderate inflation and weakness outside the US.
  • This divergence is pushing the USD higher against all currencies and potentially weakening S&P500 earnings for those companies with significant foreign operations. US dollar strength will continue to be fuelled by safe haven flows and by the divergent monetary policy paths being taken by the Fed and the BoE toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.  
  • The Bank of Canada will find ample reason to remain neutral on the direction of the next policy rate move. Canada's real GDP began 3Q on a softer trajectory and the terms of trade continue to weaken. Further weakening of the Canadian dollar will be tolerated.
  • The debate between US equity bulls, who favor buying every dip, and those advising caution due to high equity valuations (see here) continues.     
  • After moderating over the summer, global disinflation concerns reemerged in September. Weaker growth in the Eurozone, Japan and China, falling crude oil and corn prices, in the dampening effect of geopolitical tensions on consumer confidence all add to global disinflationary pressures. The risk of a global deflationary shock still seems much greater than the risk of an inflationary shock. 
In recent monthly reviews, I have 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 ample cash cushioned losses in my desired portfolio in September. Both bond and equity prices corrected in September, but these corrections made only a slight dent in asset overvaluation (see here). What was interesting in September was that bonds led the sell-off through the first three weeks, but equities experienced bigger losses by the end of the month. The unstable equilibrium is nowhere near corrected. Prudence continues to favor an ample cash allocation.

Monday, 22 September 2014

Exit Ennui: The Sequel to the Taper Tantrum

In May and June of 2013, we had the "Taper Tantrum" in markets, sparked by then-Fed Chair Ben Bernanke's announcement that the Fed would begin to taper its $US85 billion per month quantitative easing (QE) program. Over a four week period from May 24 to June 21, 2013, returns on all major asset classes fell as markets adjusted to the expectation that large-scale Fed purchases of US Treasuries and Mortgage Backed Securities would end. With all asset classes posting negative returns, all types of portfolios experienced losses, but some portfolios lost much more than others.

In September 2014, we are experiencing the sequel to the Taper Tantrum, which I will call Exit Ennui. This sequel was triggered, I believe, by Fed Chair Janet Yellen's speech at Jackson Hole. There was nothing wrong with the speech. It was surprisingly balanced. While Yellen is widely perceived as occupying a position near the dovish extreme on the Hawk-Dove spectrum among FOMC members, she did not make a dovish speech at Jackson Hole. That was left for ECB President Mario Draghi and the main result was to highlight the divergence in economic performance between the world's two largest economies: US relative strength versus Eurozone relative weakness.

In the weeks since Jackson Hole, US economic data has retained a strongish bias and attention has focussed on when the Fed will begin to raise official interest rates and what form the exit strategy will take. In the wake of Yellen's Jackson Hole speech the 10-year US Treasury yield moved up from 2.34% on August 27 to 2.62% on September 16, ahead of the Fed decision on September 17. 

In the chart below, I compare returns on the ETFs that I regularly track during the Taper Tantrum with those seen to date (as of September 22) in the Exit Ennui. The returns are in Canadian dollar (CAD) terms and it is interesting to note that during the first four weeks of the Taper Tantrum, the CAD weakened 1.3% versus the USD, while in the Exit Ennui it has weakened a very comparable 1.4%.

Based upon this chart, we can make the following observations:

  • The Exit Ennui has not yet done as much damage as occurred during the first four weeks of the Taper Tantrum.
  • In both periods, all asset classes performed relatively poorly. Nominal bonds, inflation-linked bonds, credit, equities and commodities all sold off to varying degrees.
  • Inflation-linked bonds were relatively hard hit in both periods.
  • Emerging Market assets have fared relatively better in the Exit Ennui than they did in the Taper Tantrum.
  • Long-duration bonds performed relatively poorly in both episodes.
  • Commodities have performed worse in the Exit Ennui than in the Taper Tantrum
  • Within equities, Canadian equities performed relatively poorly in both episodes
Portfolio choices make a big difference during drawdown periods like the Taper Tantrum and the Exit Ennui. The chart below shows the performance of the four portfolios that I regularly track.



The traditional Canadian 60% Equity/40% Bond ETF Portfolio, which lost 3.44% during the Taper Tantrum is down just 63 basis points so far in the Exit Ennui as equities have not been hit as hard this time around. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, which lost just 2.11% in the Taper Tantrum is down 56 basis points in the Exit Ennui.

Risk balanced portfolios posted larger losses in both periods. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 7.03% in the Taper Tantrum and is down 2.42% so far in the Exit Ennui. 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, lost 4.13% in the Taper Tantrum and is down 1.10% so far in the Exit Ennui.

What this highlights, is that leverage has not been an investor's friend during periods in which markets are pricing in reduced Fed monetary accommodation. During these drawdown periods, cash is often the best asset class, which is why the 45/25/30 portfolio tends to perform best during these episodes.  
   

Tuesday, 9 September 2014

Risk Seduction: Why Markets are Rich

In a recent post, I reviewed the evidence on equity valuations and concluded that, according to the most credible metrics, US equities are close to the richest valuations on record. But it is not only equities that are expensive. Government bonds are expensive. Corporate bonds are expensive, especially high yield or junk bonds. Real estate is expensive. In short, most asset classes are expensive. This means that, while one cannot confidently forecast short-term asset class returns, one can be fairly confident that long-term returns on these asset classes will be quite low relative to recent history.

This note discusses the two main reasons why markets are so richly priced. It examines the role of central bank policies and corporate management behavior in bidding up asset prices. When central bank policies and/or corporate behavior change, asset prices will likely move, either gradually or suddenly, toward fair value. The period of transition will be a nervous one for investors.

The Role of Central Banks

Central banks have played a central role in enriching asset prices since the Great Financial Crisis (GFC). As the GFC unfolded, major central banks cut their policy rates to close to zero and, because they felt that this did not provide sufficient stimulus, resorted to various forms of quantitative easing (QE). QE involves the large-scale purchase of government bonds or private assets such as mortgage-backed securities. As central banks engage in such purchases, the size of their balance sheets expands. The charts below, from a recent report by Nikolaos Panigirtzoglou of JPMorgan, show the growth in the size of the balance sheets of the US Fed, Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) in the left hand chart and the combined expansion in US$ of the four central bank balance sheets on the right. The result has been that the total balance sheet of the four big central banks expanded from $US 4 trillion in 2008 to almost $US 11 trillion by the end of August, 2014.  


By cutting their policy rates to close to zero and providing forward guidance that policy rates would stay exceptionally low for an extended period of time, the central banks have encouraged investors reduce their holdings of cash and to take more risk. Investors have responded by bidding up prices of equities, commodities, government bonds, corporate bonds, real estate and infrastructure assets. By undertaking QE, central banks have provided the liquidity to support investor's risk-taking. 

The result is that many equity markets are richly-valued, while government bond yields have fallen back toward post-GFC lows more than five years into the tepid global recovery. Corporate and emerging market bond yield spreads over US Treasuries are near their pre-GFC lows. Real estate prices in many countries are at record highs. As Panigirtzoglou argues, "Asset yields are mean reverting over long periods of time and thus historically low levels of yields in bonds equities and real estate are unlikely to be sustained forever."



Corporate Behavior and the Bonus Culture

The second, but much less discussed source of overvaluation of asset prices is corporate behavior, specifically what is known as the “bonus culture”. Andrew Smithers has developed the most insightful analysis of this change in corporate behavior brought about by changes in the way that management is compensated.

As Smithers explains in his new book, The Road to Recovery, the shift in executive compensation systems over the past two decades to rely heavily on bonuses combined with changes in corporate accounting rules have increased both management’s incentive and ability to overstate corporate profits. This means that profits are regularly overstated in good times and then understated through write-offs during bad times. 

The change in accounting rules that made this possible was the change from “marked to cost” to “marked to market”. With marked to market accounting, changes in asset prices, either positive or negative, make a greater contribution to reported corporate profits and thereby make profits much more volatile. This is good for corporate managers because, as Smithers points out:
As bonuses usually depend on changes in profits, companies’ managements will usually be able to benefit from both over- and understated profits. When profits are overstated, they will rise more than they otherwise would have done and bonuses will rise with them. When profits are understated in one year but not the next, the rise in profits will also be exaggerated, together with the associated bonuses. Managements therefore want profits to be volatile. As management gets what management wants and what management wants has been greatly eased by marked to market accounting, the result has been the growth of periodic write-offs.
Assets are therefore periodically written up or written down. The associated write-offs are either an admission that profits have been overstated in the past or a promise that management will try to overstate them in the future.

Smithers also explains how the bonus culture leads corporate management to favor buying back corporate equity over investing in new capital equipment and software. Equity buy-backs increase earnings per share in the short term, while investment in capital equipment reduces earnings per share over the same period. Increasing earnings per share increases management bonuses and so is the more attractive choice. 

Stock buybacks are a major cause of equity overvaluation. The chart below, from a recent article by Henry Blodgett posted on Business Insider, shows that in Q1 of this year “equity buybacks hit almost the highest level in history -- exceeded only by a couple of quarters in 2007, just before the market tanked”.



By Blodgett’s calculation, stock buybacks, which reached US$159 billion in 1Q14, have outstripped new share issuance for several years and, as a consequence, the total number of shares outstanding for S&P500 companies is now lower than it was in 2005. Share buybacks have been financed by corporate cash flows, which have been waning recently, and by issuance of debt which has levered up corporate America.

What will end the Overvaluation?

The two main drivers of asset overvaluation are central bank policies, (specifically near-zero policy rates and large-scale QE) and corporate behavior (specifically overstatement of profits and equity buy-backs). Overvaluation will likely diminish, perhaps rapidly, when these policies and behavior change.

Quantitative easing by the Fed is set to end in October and the policy rate is expected to begin to rise some time in the first half of 2015. On previous occasions when the Fed has attempted to end QE, equities have weakened and bond yields have fallen as investors feared that the economy would slump as monetary stimulus was reduced. However, in this instance, US growth appears to be accelerating, the economy is operating closer to full capacity, and the Fed is expected to follow up termination of QE with an increase in the policy rate. If the growth acceleration continues and inflation remains stable, the US Treasury bond market is likely to sell off. If the growth acceleration continues and inflation moves above target, all asset markets are likely to weaken. A potential mitigating factor is that the ECB may be preparing a new round of large scale QE, but this might just add to volatility in foreign exchange and other markets.

Stock buy-backs are likely to continue as long as corporate cash flows remain solid and bond investors remain willing to buy corporate debt at relatively narrow spreads over government bonds. However, there are signs that cash flow growth has peaked and that investors are becoming wary of corporate credit. Should corporate profits and cash flows be squeezed by the faster wage growth that Fed Chair Janet Yellen wants to see, the massive flows into high yield and investment grade corporate debt driven by investors search for yield could reverse. Strategists have pointed out recently that regulation has reduced the willingness and ability of bank-owned dealers to make liquid markets in corporate debt. Should investors decide to significantly reduce their corporate debt holdings, not only would credit markets suffer potentially serious losses, but a major source of funding for equity buy-backs could dry up.

It is, therefore, for good reason that the Fed and the Bank of England are likely to move toward tightening policy with great caution. Beginning the process of reversing years of extreme monetary ease could prove quite unsettling to richly-valued financial markets.