Thursday, 27 February 2014

Tiff, We Hardly Knew Ye!

Tiff Macklem will soon be leaving his post of Senior Deputy Governor of the Bank of Canada to take on the role of Dean of the Rotman School of Management at the University of Toronto. On February 7,  Macklem gave his final Bank of Canada speech, titled "Flexible Inflation Targeting and Good and Bad Disinflation". It is perhaps the most insightful statement yet on how the Bank of Canada's views on the inflation process have evolved in the years since the Great Financial Crisis. 

With the BoC preparing for the rate decision on March 5, Macklem's clearly expressed views on why inflation has fallen below the BoC's 2% target and remained there for 20 months should be required reading for all Bank of Canada watchers.

The key insights in Macklem's speech include:

  • the most important driver of Total CPI inflation in Canada is global Total CPI inflation,
  • domestic factors are important in the dynamics of Core CPI inflation in Canada,
  • the output gap does not play a significant role in determining core inflation,
  • inflation expectations remain fairly stable around 2%, but there is a risk that expectations will decline if inflation remains persistently below 2%,
  • increased domestic retail competition appears to be a factor holding inflation below the 2% target,
  • disinflation caused by increased competition and/or productivity is considered "Good Disinflation" by the BoC and does not require a monetary policy response,
  • disinflation caused by a shortfall of aggregate demand is considered "Bad Disinflation" by the BoC and does require a monetary policy response.

Total CPI Inflation

Macklem explains, "Looking at the relevance for Canada of global inflation developments, it is evident that Canada’s total inflation rate co-moves substantially with the common factor in inflation among advanced economies, underscoring the importance of energy and food prices for movements in total CPI inflation in Canada." Most of the variation in Canada's total CPI inflation is explained by movements in global inflation, which in turn are driven by movements in global food and energy prices.

Core Inflation and the Output Gap

Macklem goes on to point out that the conventional assumption that core inflation is significantly influenced by the output gap is not borne out the evidence. Econometric estimates of the influence on core CPI inflation of the output gap suggest a coefficient value of around 0.1 which does not meet standard tests for statistical significance. Given the BoC's assessment that the current negative output gap is about 1¼%, Macklem notes that the output gap would predict core inflation of 1.9%, well above recent levels of just over 1%. This implies that a large positive output gap of 5 to 10% of potential GDP would be required to return core inflation to the 2% target. As Macklem points out, "This is not realistic".

Inflation Expectations

Inflation expectations are fairly stable, but are under downward pressure as long as inflation continues to fall short of the 2% target. Consensus forecasts by economists expect inflation of 1.5% in 2014 and the majority of respondents to the BoC's Business Outlook Survey expect inflation between 1% and 2%. Macklem argues that there is "little evidence that inflation expectations are becoming unhinged from the 2 per cent target", but acknowledges that if disinflation persists, there is a risk that inflation expectations will also decline. 

Retail Competition

The entry to Canada of many big-box retailers including Walmart and Target appears to be putting downward pressure on consumer goods prices. Macklem indicates that BoC research suggests that this factor, not included its inflation model, may account for as much as 0.3% of the weakness in core inflation.

Good and Bad Disinflation

Macklem concluded his speech by acknowledging that the BoC cannot fully explain the weakness of CPI inflation, but that increased retail competition appears to be an important factor. He then argues that disinflation caused by retail competition is "Good Disinflation" and contrasts it with disinflation caused by weak aggregate demand which he refers to as "Bad Disinflation". With this distinction made, he argues that the BoC does not need to adjust monetary policy to resist Good Disinflation, which he believes will abate on its own over the next year or two. However, should there be a weakening in aggregate demand relative to the BoC's current expectations, then it would be appropriate for the Bank to respond by easing monetary policy.

This is a new twist for the BoC but is reminiscent of a distinction made several years ago between "Type 1" and "Type 2" exchange rate depreciations as a rationale for BoC inaction. That distinction was difficult to measure empirically and was eventually dropped.  


Tiff Macklem's final speech of his BoC career, in my view, is a model for how the Bank of Canada should communicate with markets and the general public. We can only regret that we won't have his clear communication in the future.

As to the implications for near term monetary policy, it seems clear that, for now, the BoC is willing to consider the 20-month period of below-target inflation as a case of "Good Disinflation", which does not require a monetary policy response in the form of an interest rate cut. I doubt that the Good vs. Bad Disinflation distinction will have any longer shelf life than Type 1 vs. Type 2 currency depreciation distinction did.

It is also clear, however, that the BoC lacks a full explanation of persistently below-target inflation. The BoC is wary that any further disinflationary shock could push inflation further below target and thereby risk "unhinging" inflation expectations to the downside. Should that occur, returning inflation to target could take considerably longer than six to eight quarter horizon over which the BoC aims to return inflation to the 2% target. Consequently, the BoC is unlikely to change its forward guidance, which Macklem expresses like this: "The timing and direction of the next change to the policy rate will depend on how new information influences [the] balance of risks." 

Good luck with your future endeavours, Tiff. You will be missed.    

Monday, 3 February 2014

Canadian ETF Portfolios: January Review and Outlook

In January, turmoil in emerging markets, some disappointing US economic data, and continued tapering of QE by the Federal Reserve coincided with a major selloff in global equity markets. Over-extended equity valuations have made the selloff more violent. US and most other DM bond yields posted a contrarian rally, as markets increasingly focused on deflationary forces emanating from key EM economies and the Eurozone. Evidence on US growth remained solid, but there were some important disappointments in January. The December US employment report posted a much weaker-than-expected gain of 74,000 payroll jobs, but the unemployment fell to 6.7% from 7.0%. The Citi US Economic Surprise Index, which had surged into early January, fell back considerably by the end of the month.

Middle East tensions remained subdued as the US-led tentative agreement with Iran over its nuclear program held together and despite the fact that Syria made very limited progress on destroying its chemical weapons and. Crude oil prices were weaker, as the WTI futures price traded down to $92/bbl in mid-January from its end-December level of $100/bbl, but rallied back to $98/bbl by January 31st.

Gold prices rebounded, however, as turmoil in some notable EM economies (Turkey, Thailand, Argentine and Ukraine) spilled over into DM markets for risky assets and gold rose to $1240 after closing December at $1202. Gold and inflation-linked bonds, the worst performing assets of 2013, were among the best performing assets in January.

With crude oil weakening but gold prices rising, the Canadian dollar remained on a weakening trend. The Fed’s decision to proceed with tapering, combined with the Bank of Canada’s more dovish stance, contributed to a sharp weakening of the C$, which fell 4.4% against the US$ in January, with USDCAD rising to 1.113.

Global Market ETFs

Monthly Performance for January

EM turmoil and weaker US data dented sky-high equity market sentiment in January. The S&P500 hit a record closing high on January 15, but fell in the last two weeks of the month to close at 1783 down from 1842 at the end of December. Global equity ETFs posted negative returns in January. Most major markets declined in local currency terms, but given the weakness of the C$, Canadian investors saw mixed global equity performance in CAD terms. The weaker global equity ETFs included Emerging Markets (EEM), which returned -4.5% in CAD terms, Japan (EWJ)  -2.4%, and Eurozone (FEZ) -1.5%. Gainers included US (SPY), which was up +0.9% in CAD terms, US small caps (IWM) +1.6%, and Canada (XIU) +0.5%.

Commodity ETFs performed well in CAD terms. The Gold ETF (GLD) returned 8.1% in CAD terms, while the iShares GSCI commodity ETF (GSG) returned 2.3% as commodity price weakness was more than compensated for by C$ weakness. 

Global Bond market ETF returns were surprisingly strong in January, with DM bond ETFs outperforming EM bond ETFs by a wide margin. Canadian bonds (XBB) returned 2.4% in January. The best performance came from US bond ETFs which benefitted Canadian investors as bond yields fell and the C$ weakened. US long bonds (TLH) returned +8.8% in CAD terms. Non-US global government bonds (BWX) posted a return of 5.0% in CAD terms. Emerging Market bonds underperformed in January as USD-denominated bonds (EMB) returned +3.7%, while EM local currency bonds (EMLC) returned -0.02% in CAD terms as EM currencies weakened as capital was pulled out of EM assets.

Inflation-linked bonds (ILBs) posted a strong rebound in January. Canadian RRBs (XRB) returned +4.2%, US TIPs (TIP) returned +6.8% in CAD terms, and non-US ILBs (WIP) returned +3.3%.

US investment grade (LQD) and high yield (HYG) bonds also posted strong gains in CAD terms, returning 6.5% and 5.0% respectively. Canadian corporate bonds (XCB) returned 2.3%.

Global ETF Portfolio Performance for January 2014

In January, Canadian ETF portfolios more heavily weighted in Gold, US nominal bonds, and inflation-linked bonds, with limited or zero weight in EM assets performed best.

The traditional Canadian 60% Equity ETF/40% Bond ETF Portfolio gained 237bps in January, benefitting heavily from the currency gains on its unhedged foreign equity exposure. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned 116 bps.

Risk balanced portfolios, which were disappointing in 2013, performed very well in January. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs discussed above, gained 424bps in January. The strong returns in the levered risk balanced portfolio were attributable to strong gains in the leveraged positions of nominal and I-L bonds. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds and ILBs and more exposure to corporate credit, returned 348bps in January.

Outlook for February

The investment environment changed significantly in January and the near-term prospects contain substantial risks. Key developments that markets will be watching in February will include:

·   The US debt ceiling, which looked like a contained issue a month ago, takes on added importance in the current volatile market environment.
·   Over the past month, economic data have been mixed, but key data points including the December employment report and the January ISM report, released on Feb. 1, were much weaker than expected. Weather was a factor in both reports, and rebounds could follow. The US Economic Surprise Index was very strong in early January, but has fallen quite sharply since then. The US ISM Manufacturing PMI slumped to 51.3 in January from 56.5 in December, and the New Orders index collapsed to 51.2 from 64.4. At this stage, the US macro data is not providing a clear picture on the economy’ momentum.
·   Concerns about global deflation continued to rise, with warnings from the IMF and further soft inflation readings in the US, Eurozone, Asia and Canada. Failure of inflation to stabilize and move higher over the next few months could become an increasing concern for financial markets.
·   Emerging markets will remain a focus in financial markets. Financial conditions have tightened meaningfully in all EM countries and very sharply in countries like Turkey and Brazil. The Peoples’ Bank of China has moved to ease rising funding rates for banks, but this may be a symptom rather than a cure for China’s over-expansion of credit in the shadow banking system.

In this environment, industrial commodity prices remain under downward pressure in early 2014.  Copper prices have continued to edge down.

In a mid-January post on Inflation and Deflation Scenarios, I pointed to Russell Napier’s advice to watch inflation expectations (measured by break-evens), copper prices and credit spreads. In the short time since that post, each of these indicators have moved further toward the outcomes consistent with the deflation scenario. I noted at the time that Risk Balanced portfolios would perform best in the Deflation scenario and that it what happened in January. 

Last month, I concluded that “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 remains likely that it will be triggered by a further sell-off in government bond markets and then spread into the credit and equity markets.”

That prognostication proved half-right. The equity market correction arrived, but it was EM tensions, some weaker than expected economic data, and growing deflation concerns the proved to be the trigger, not the further bond market sell-off that I and many others expected. How deep the current correction in risky assets becomes will depend on whether the concerns that triggered it multiply or diminish in the weeks ahead. The US employment report on February 7 will be the first test, but is unlikely to be decisive. The turmoil in EM, and China in particular, and further evidence on inflation dynamics will be more important.

Raising cash was a good strategy in January. If US equities, which broke key support levels on February 3, do not rebound to finish higher this week, raising cash will continue to be a good strategy. Putting that cash to work in top quality corporate bonds may be the best alternative until the situation becomes more settled.