Thursday, 31 July 2014

Global ETF Portfolios for Canadian Investors: July Review and Outlook

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

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

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

Global Market ETFs: Monthly Performance for July

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

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

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

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

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

Year-to-date Performance through July

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

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

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

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

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

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

Global ETF Portfolio Performance through July

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

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

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

Outlook for August

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

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

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

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

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

Monday, 21 July 2014

Inflation or Deflation: Revisiting the Scenarios

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

1.     Rising Inflation,
2.     The comfortable Consensus, and
3.     Slide toward Deflation.

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

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

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

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

Inflation Leading Indicators

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

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

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

Corporate bond spreads have closely tracked the consensus view.

Equity, Bond and Currency Markets

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

To summarize the scenarios and the actual outcomes:

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

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

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

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

Implications for Canadian ETF Portfolios

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

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

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

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

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


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

At mid-year, one must ask: If the economy is veering toward the Rising Inflation scenario, why have 10-year US Treasury yields fallen, fuelling outperformance by the Levered Risk Balanced Portfolio? The likely reasons are: 
  • US growth in 1H14 did not live up to Consensus expectations fueling complacency that the Fed will not move soon to head off rising inflation, 
  • Eurozone inflation has dipped toward deflation, prompting the ECB to consider new unconventional monetary easing measures, and 
  • Flaring geopolitical risks including the conflicts in Eastern Ukraine, Iraq and Gaza are supporting flight-to-safety buying of US Treasuries.

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

Tuesday, 1 July 2014

Canadian ETF Portfolios: 2Q Review and Outlook

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

Economic signals released in 2Q were very mixed: 

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

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

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

Global Market ETFs: Performance for 2Q14

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

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

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

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

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

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

Global ETF Portfolio Performance for 2Q14

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

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

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

Outlook for 3Q14

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

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

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

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

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

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