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.