Tuesday, 14 January 2014

Inflation or Deflation: Implications for Portfolios

In a recent post on The Outlook for Global Inflation in 2014, I noted that the consensus forecast for global inflation appears to be the lowest on record. I also pointed out that while inflation is considerably lower in Developed Market (DM) economies than in Emerging Market (EM) economies, current inflation drivers are much stronger in DM than in EM. In that post I suggested that “with the global economy building some momentum going into 2014, and with the lagged effects of massive monetary policy accommodation still in the pipeline, it seems very possible that global inflation could be higher in 2014 than the record low forecast”.

Subsequent to that posting, I read an insightful research note by the estimable Russell Napier of CLSA written in November 2013 entitled “An ill wind”. In the note, Napier argues that falling export prices from Japan, China and Korea constitute an ill wind from the East that will continue to blow in 2014 risking further declines in inflation in the US, Eurozone and other DM economies.

Napier’s note got me thinking that preferred portfolio allocation in 2014 will be very different in the scenario I outlined, in which inflation turns out to be higher than expected, than in as Napier's scenario, which anticipates an accelerating move toward deflation. As this post will explain, either upside surprises on inflation or a move toward deflation could have highly negative outcomes for equity-heavy portfolios.
Three Scenarios

A very useful contribution of Napier’s note is that he draws attention to three leading indicators to keep an eye on to help gauge which direction inflation is likely to take. He urges investors to watch TIPS-implied inflation (using 5-year breakevens), copper prices and corporate bond spreads, which he believes can give an early read on whether benign disinflation it tipping towards dangerous deflation.

I have put together three scenarios to illustrate three different inflation outcomes:

1.     higher-than-expected Inflation,
2.     the comfortable Consensus, and
3.     slide toward Deflation.

The scenario paths of US CPI inflation are show in the chart below. The comfortable Consensus expects US inflation to continue to fall in 1Q14 but then to rise modestly to 1.6% in 4Q14. In the higher than expected inflation scenario, stronger US growth against a reduced potential growth rate results in a quick move up in inflation to 2.5% by yearend. In the Napier-type deflation scenario, US inflation continues to drop well below 1% as 2014 unfolds.   

Under these three scenarios, inflation expectations as expressed in US TIPs Breakevens would unfold very differently as shown in the chart below.


Copper prices, which are very sensitive to growth and inflation expectations would also trace out very different paths in the three scenarios as depicted in the chart below, which shows expected copper price changes over the year.

Finally, corporate bond spreads would behave very differently under the three scenarios. Napier’s review of the behavior of the Baa corporate bond spread ahead of the stock market declines of 1998, 2001 and 2007-08 suggests that corporate bond spreads do tend to spike in deflationary episodes, but that they are not as timely a lead indicator as TIPs breakevens. Nevertheless, these deflationary experiences all saw spreads widen to more than 300 basis points.

Equity, Bond and Currency Markets

Markets would behave very differently in the three scenarios outlined above. I have relied on Napier’s research and my judgment of recent market correlations to come up with what I believe 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 the likely paths of these key market indicators in the three different scenarios.

To summarize the likely market outcomes:

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

·  The Inflation scenario, which sees a rise in US CPI inflation to 2.5% 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 Napier-like 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.

Implications for Canadian ETF Portfolios
Asset class returns would vary quite dramatically across the three scenarios that I have sketched out. The chart below depicts the expected Canadian dollar total returns on the major asset class ETFs that I write about in this blog under each of the scenarios. The results indicate that investors are walking a tightrope between deflationary and inflationary outcomes. Let us hope that the Consensus proves close to the mark because the outcomes in both tails of the inflation probability curve are not good.

Given this set of ETF returns, how would different portfolio structures perform? The charts below show expected returns to four different portfolios that I regularly track under each of the three scenarios.

The Consensus scenario provides unexciting returns for Canadian investors. But after strong returns in 2013, this would not be a bad outcome. Equity and credit heavy portfolios will perform best if the Consensus proves accurate. Risk balanced portfolios that have larger weights in government nominal and inflation-linked bonds and commodities would underperform as they did in 2013, with the levered version of this portfolio structure performing worst.

The Deflation scenario would provide negative returns for Canadian investors if they were invested in conventional equity and credit-heavy portfolios. Such portfolios would be supported to some extent, however, if they have significant foreign content as Canadian dollar weakness would tend to temper losses on USD denominated ETF exposures to foreign stocks, credit and commodities. Global Risk Balanced portfolios would perform best in the Deflation scenario, as they would benefit from their larger exposure to government debt, which would benefit from falling 10-year UST yields. Inflation-linked bonds would underperform nominal bonds but would still provide positive returns. The Levered Risk Balanced portfolio would be the best performing structure in the Deflation Scenario, possibly reaching a double-digit return.

Finally, the Inflation scenario would be highly damaging to all of the portfolios. Equities, credit and nominal government bonds would all perform poorly in the event of significant upside inflation surprises that would hasten tapering of QE and bring forward expectations of central bank policy rate increases. Exacerbating these effects for Canadian dollar investors would be the effect of Canadian dollar appreciation. In fact, the portfolio that would perform best in this scenario would be the risk averse 45% Equity, 25% bond and 30% Cash portfolio, as the large cash position would mitigate the portfolio declines. The Levered Risk Balanced portfolio would be the worst performer as bond losses would be larger because of the large exposure to domestic and foreign nominal and inflation-linked bonds.


Looking at the three scenarios, one is struck by the continuing risks to investing in the post-financial-crisis environment which has been characterized by unconventional monetary policies that have encouraged investors to move into risky assets and led to rich valuations for equities, bonds and credit. Given these valuations, the Consensus macro scenario, in which the Fed tapers and gradually ends Quantitative Easing, would provide only moderate positive returns. If the current Consensus does not play out, as it usually doesn't, there are great risks to both the higher-than-expected Inflation scenario and the slide toward Deflation scenario sketched out by Russell Napier.

If one leans toward the higher-than-expected Inflation scenario, the preference would be the conservative 45% Equity, 25% Bond, 30% Cash portfolio.  If one leans toward the slide toward Deflation scenario, the preference would be the levered global Risk Balanced portfolio.

The most important takeaway from this analysis is the importance of taking a flexible approach and being prepared to make substantial asset mix shifts if the economy veers toward either the Inflation scenario or the Deflation scenario in 2014.

Friday, 3 January 2014

Canadian ETF Portfolios: December Review and 2014 Outlook

In December, stronger US economic data and the decision by the Federal Reserve to begin to taper its massive QE program provided a further boost to equity markets and pushed US bond yields to new 5-year highs. Many strategists remain cautious toward equities based upon over-extended valuations, but expect equities to continue to outperform bonds in 2014. Evidence on US growth continued November’s improvement by surprising on the positive side in December. The November US employment report posted a stronger-than-expected gain of 204,000 payroll jobs, but the unemployment rate edged up to 7.3% from 7.2%.

Middle East tensions remained subdued in the wake of the Russia-led agreement committing Syria to destroy its chemical weapons and the US-led tentative agreement with Iran over its nuclear program. Crude oil prices rebounded, as the WTI futures price recovered to $100/bbl at the end of December from its November low of $92.

Gold prices continued to weaken, however, as concerns that the Fed would proceed with tapering of QE proved correct and gold fell to $1202 at the end of December, after closing November at $1251. Gold and inflation-linked bonds continued to be the worst performing assets of 2013.

Despite the rebound in crude oil prices, the Canadian dollar continued to weaken. The Fed’s decision to proceed with tapering, combined with the Bank of Canada’s more dovish stance on tightening, contributed to weakening the C$, which fell 0.3% against the US$ in December, with USDCAD rising to 1.0641.

Global Market ETFs

(i) Monthly Performance for December

Stronger US data seems to have been ample justification for the Fed to begin tapering and global equity markets reflected this growth optimism. The S&P500 hit a record closing high of 1848 on December 31. Global equity ETFs posted solid returns again in December led by Eurozone (FEZ), which returned +2.8% in CAD terms, US (SPY) +2.3%, Japan (EWJ) +0.9%. US small caps (IWM) returned 1.9%. Canada (XIU) underperformed, returning 0.9%, despite the rebound in crude oil prices. Emerging Market equities (EEM) performed poorly as the taper began (as they did in the spring), returning -1.0% in CAD terms.

Global Bond market ETF returns were mostly negative in December as growth optimism and the Fed’s decision to taper weighed on prices. Canadian bonds (XBB) fell for a second straight month, returning -0.6% in December. US long bonds (TLH) returned -2.1% in USD terms but with the weakening of the C$, the return was -1.8% in CAD terms. Non-US global government bonds (BWX) fared better, posting a return of -0.2% in CAD terms. Emerging Market bonds outperformed in December as USD-denominated bonds (EMB) returned +0.2%, but EM local currency bonds (EMLC) returned -0.5% in CAD terms as EM currencies weakened on the tapering news.

Inflation-linked bonds (ILBs) once again were to be avoided in December. Canadian RRBs (XRB) returned -2.2%, US TIPs (TIP) returned -1.2% in CAD terms, and non-US ILBs (WIP) returned -0.5%.

US investment grade (LQD) and high yield (HYG) bonds posted meager gains in CAD terms, both returning 0.2% in December. Canadian corporate bonds (XCB) underperformed with a return of -0.5%.

 Annual ETF Returns for 2013

The year began with the US fiscal cliff being narrowly avoided as US lawmakers agreed to extend the deadlines for the US Debt Ceiling and government shutdown. As 1Q13 unfolded, it became clear that without a deal, an end to Bush tax cuts for high income earners, an end to the payroll tax cut, and “sequestration” of US government spending would automatically kick in. The Fed, fearing that the fiscal drag entailed by these changes would stall the economy, made it clear that its open ended quantitative easing would remain in place. As the economy fared somewhat better than expected, investment returns got off to a good start in 1Q13. In May, Fed Chairman Bernanke surprised markets by suggesting that the Fed could begin tapering within months, setting off a sharp sell-off in global markets. Bernanke and other FOMC members provided reassurances that tapering was not tightening, but the markets remained unconvinced as growth struggled through mid-year. By early September, the consensus view was that the taper would begin at the September FOMC meeting, but the Fed surprised again by announcing that it would continue to purchase $85 billion of bonds per month. In 4Q13, US economic data showed some improvement and despite inflation running well below the Fed’s desired, the Fed announced that it would reduce its bond purchases to $75 billion in January 2014.

In this 2013 environment of sluggish but improving US growth, weak inflation, and large scale Fed bond purchases, global short-term interest rates remained at very low levels, with real rates (after inflation) negative in most developed countries. DM central bank policies, including Abenomics in Japan, represented unprecedented stimulus for a global economy that was in its fourth year of a weak economic recovery. Investors responded to global policy actions, by reaching for higher yields and avoiding near zero cash returns. This meant that money continued to flow into equities and higher yielding corporate bonds. With inflation subdued and the Fed promising to end QE, gold, inflation-linked bonds, and emerging market currencies performed very poorly. The chart below shows annual returns for Global Market ETFs in Canadian dollar terms.

In 2013, the best global ETF returns for Canadian investors were in US and other global equities. The S&P500 rose 26.9% for the year. This resulted in a total return (assuming dividend re-investment) on the S&P500 ETF (SPY) of 32.3% in USD terms and 38.0% in CAD terms. On the same basis, the iShares unhedged Japan equity ETF (EWJ) returned +31.1%, while the hedged iShares Canada ETF (CJP) returned a stunning 55.9%. The SPDR Eurozone equity ETF (FEZ) returned +30.9% in CAD terms. US small caps (IWM) returned 41.7%, outperforming the large cap SPY. Canada (XIU) lagged these foreign equity ETFs badly returning 9.9% in 2013. Emerging Market equities (EEM) were the weakest as Fed tapering fears led to capital outflows and weaker currencies, resulting in a -1.2% return in CAD terms.

Commodity ETFs performed poorly. The Gold ETF (GLD) returned -27.4% in CAD terms, while the iShares GSCI commodity index returned -0.6%.  

Global Bond market ETF returns were weak but mixed in 2013. Foreign bond ETFs benefited from currency strength relative to the Canadian dollar. As bond yields rose in anticipation of tapering, the DEX Universe Canadian bond ETF (XBB) returned -1.4% in 2013, while the Canada Long Bond ETF (XLB) posted a serious loss of -9.9%. US long bonds (TLH) returned -6.5% in USD terms, but with the weakening of the C$, this translated into a -2.5% return in CAD terms. Non-US global government bonds (BWX) fared better, posting a return of +0.3% in CAD terms. Emerging Market bonds suffered from the same problems as EM equities. USD-denominated EM bonds (EMB) returned -2.6%, while EM local currency bonds (EMLC) returned -6.2%.

Inflation-linked bonds (ILBs) were a major casualty of the combination of unexpectedly low inflation and tapering anticipation in 2013. The Canadian real return bond ETF (XRB) was the worst performer, returning -14.1%. US TIPs (TIP) returned -10.0% in USD terms, but thanks to USD strength, lost just 5.1% in CAD terms. Non-US ILBs (WIP) fared better, returning -1.7% in CAD terms.

In corporate bond space, the US high yield bond ETF (HYG) posted a solid return of 11.0% in CAD terms in 2013, while the US investment grade bond ETF (LQD) returned 2.3%. The Canadian corporate bonds ETF (XCB) eked out a return of +0.9%.

Global ETF Portfolio Performance for 2013

Over the course of 2013, Canadian ETF portfolios more heavily weighted in foreign equities and high yield bonds, with limited or zero weight in commodities and inflation linked bonds performed best.

The traditional Canadian 60% Equity ETF/40% Bond ETF Portfolio gained 93bps in December, bringing its YTD return up to 16.1%. A less volatile portfolio, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned a very competitive 14.0%.

Risk balanced portfolios, which performed well in recent years, were disappointing in 2013. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs discussed above, lost 49bps in December, lowering its YTD return to 1.8%, after it suffered a severe 8.1% drawdown from April 26 to June 21 during the “taper tantrum” selloff. The weak returns in the levered risk balanced portfolio were attributable to the sell-off in the leveraged positions of Canadian nominal and I-L bonds. An Unlevered Global Risk Balanced Portfolio, which has less exposure to government bonds and ILBs and more exposure to corporate credit, returned 43bps in December, raising its YTD return to 9.3%.

Expectations for 2014

The New Year will undoubtedly bring a new set of surprises for global markets. Key developments that markets will be watching will include:

·   Global growth forecasts for 2014 were marked down from July through December. Forecasters are still relatively optimistic that DM economies will grow faster in 2014 than in 2013, while EM economies are expected to slow further in the year ahead. 
·   Over the past month, US economic data have been stronger than expected. The Citi US Economic Surprise Index rose from -4 in early November to +50 in late December. The US ISM Manufacturing PMI eased down to 57.0 in December from 57.3 in November. While the high level if the ISM indicates a pickup in manufacturing activity in early 2014, it is often better to sell equities at high ISM readings than to buy them.
·   Globally, inflation fell to the lowest readings since the Financial Crisis in Q413. Consensus forecasts for 2014 inflation are the lowest on record. This means that any uptick in inflation this year will be a negative surprise for financial markets.
·   DM central banks, which have focused heavily on supporting stronger recoveries and reducing output gaps, are seeing positive signs on this front. While stronger growth may lead markets to believe that the Fed and other central banks will reduce monetary stimulus sooner, if this is combined with an unexpected uptick inflation, the reaction in the bond and equity markets is likely to be quite negative.    

In this environment, we will keep close watch on commodity prices early in 2014.  Global excess supply has weighed on oil prices and Fed tapering has been kryptonite to gold. A pickup in growth could see commodities -- the dogs of 2013 -- stage a recovery in early 2014.

Last month, I concluded that, “the continued run-up in equity prices has several high profile valuation gurus, including Robert Shiller and Jeremy Grantham warning that US equity valuations are rich. Yet both are stopping short of sounding the alarm …
The market is clearly vulnerable to a 10+% correction over the next few months, but this seems more likely to be a 2014 story than a December 2013 event”.

This proved correct. But looking ahead to 2014, equities, credit and government bonds are all richly valued. As the Fed continues to taper, the risk of a sharp equity market correction continues to loom. When such a correction begins, it is likely that it will be triggered by a further sell-off in government bond markets and then spread into the credit and equity markets.