Market Priced Volatility and Real-World Uncertainty

Economic expansion in advanced economies is expected to continue into next year, led by rising household consumption and business investment. The U.S. Fed is expected to continue slowly unwinding QE while raising rates, and the ECB is likely to begin to taper its asset purchases during 2018. Prospects for emerging economies have improved as Brazil and Russia emerged from recession. China’s economy is likely to slow, but only gradually.

While the world is experiencing synchronous growth, record low volatility has created low correlations within and among asset classes. What appears to be a Goldilocks economy is coexisting in a low volatility environment that may be a trap, a situation where excessive monetary stimulus keeps asset prices rising and volatility low across markets even though real economic risks are rising. Central bank stimulus directly lowers risk premiums and volatility in rates and credit markets, pushing investors into riskier assets to generate sufficient returns.  However, the inequality resulting from this stimulus has increased geopolitical instability.

Concern remains low as markets continue moving higher and volatility remains at record lows. The gap between soft economic data (survey-based) and hard data (official data releases) has widened. Optimistic soft data and low inflation have helped produce positive returns while hard data has detracted. Meanwhile, we haven’t seen emotional reactions to geopolitical risks that have unknown consequences. The U.S. is an open economy and foreign capital flows will go where conditions are most attractive and geopolitical risk and policy errors will at some point be reflected in markets, eventually bringing volatility back.

Though efforts to reduce leverage and capitalize banks since the crisis have resulted in a safer financial system, we currently have more indebted governments, higher inequality and increased geopolitical risks. These opposing factors have created a divergence in market volatility and real-world uncertainty.

Rising wealth inequality coupled with lack of social mobility provides the economic conditions for a rise in protest politics. The Brexit referendum and the U.S. and French presidential elections spurred protests. Unexpected results from the UK referendum and U.S. elections triggered an increase in global economic policy uncertainty. Neither event sparked a market selloff, thanks to quick easing actions from the BoE and an improvement in U.S. growth and fiscal policy. Future risks may be the catalyst for a market response. These risks include tensions in the Middle East and between the U.S. and North Korea and investigations over President Trump’s Russian links.

Currently, foreign money is making its way to the U.S. bond market suppressing long-term U.S. rates, causing the yield curve to hold at some of its narrowest levels in a decade while inflation remains dormant. Although the Fed can continue raising short-term rates, long-term yields would remain low until inflation accelerates. This relationship could be tested in 2018 as the Fed plans to begin reducing its balance sheet assets. We will continue to monitor this and the apparent disconnect between geopolitics and the markets.

 

 

Four Themes

1.The Puzzle of Low U.S. Inflation

There is concern that central bankers and creating uncertainty regarding the sustainability of the recovery by steering the economy without the benefit of a reliable theory of what drives inflation today. Inflation has been lower than expected for several years, explained by lower growth. Central banks can more slowly normalize policy and reduce the risk of a policy mistake that would cause a recession if inflation is low and there is less economic overheating. Equities prefer low inflation, since low rates on cash and bonds make stocks look more attractive.

Low inflation results in a weakening economy, lower earnings growth, and a future problem with central bank’s ability to raise the economy out of the next recession. Central banks in developed markets collectively identified this concern and have committed to do everything they can to bring inflation up to their target rates.

Since the beginning of 2017, U.S. growth has improved while inflation remains below target. The Fed and other central banks have set their inflation targets too low given the realities of their economies. There has been downward pressure on the long-term neutral rate of interest applied by rising inequality, growing regional savings gluts and aging populations that slow demand. The ability to lower rate, which has been a primary tool for fighting recession, has become less effective.

Part of the low inflation problem relates to the dollar. Large, abrupt swings in the dollar tend to be more correlated with large, abrupt swings in import prices with much less pass-through to inflation.

The broad dollar index is now at its lowest since April 2016. Fed models indicate that for every 10% trade weighted appreciation in the dollar, core PCE inflation is reduced by 0.5% in the two quarters following the dollar’s move and the four-quarter effect is to reduce core PCE inflation by about 0.3%¹. Therefore, it is conceivable that much of the deceleration in core PCE inflation from 1.9% at the start of this year to 1.4% as of August was due to the dollar’s prior appreciation¹.

 

2. The Unknown Impact on the Yield Curve with the Reversal of Unconventional Monetary Policy

A gradual normalization of bond yields as growth improves and central banks exit QE should be positive for financial stability. By next year most central banks are expected to begin the process of unwinding the $20 trillion in financial assets that they purchased over the past decade.  These outflows could lead to asset declines and liquidity disruptions.  The timing would be determined by the pace of central bank normalization. While policy rates are rising in the U.S., Canada and U.K., financial conditions remain loose due to demand for bonds, creating headwinds for those central banks who are moving in the tightening direction.

The Federal Reserve has begun to unwind the massive balance sheet that grew significantly following the financial crisis of 2008, to above $4.5 trillion. The process of shrinking the balance sheet would be gradual and take many years, initially reducing at $10 billion a month.

The added complication is that it is impossible to know exactly what impact QE has had, in part because it is impossible to disentangle it from all the other forces affecting the economy. QE has boosted equity prices but the ripple effect on household spending and GDP has been small.  The marginal effects of QE diminished as the program expanded. There is debate about whether it is the stock or flow of purchases that matters. It is unlikely that the Fed will be able to cheapen the Treasury curve through raising the term premium via reduced reinvestment. Unconventional policy tightening is not a substitute for conventional policy tightening.

The view that the Treasury term premium will rise less materially than it fell is based on many other considerations affecting the Treasury market. They include:

 

• Balance sheet reduction may be slowed or reversed at some point due to late cycle concerns and uncertainty around timing the business cycle.
• The actions of other major QE central banks whose balance sheets wouldn’t be shrinking for years or would continue to expand even at a slower pace in future.
• The Fed has very limited ability to cheapen the Treasury market on its own. If foreign central banks hesitate to allow their own yields to rise materially, connected carry trades adjust for FX hedging risks.
• Improved stock markets may merit a safe-haven bid that preserves demand for Treasuries.

 

An additional consideration is that the initiative was more than offset by increased public-sector borrowing. Continued demand among mutual funds, pensions and insurance companies for fixed income created the opportunity for non-financial companies to ramp up issuance. It’s one of several supply factors that have been identified explaining why bond yields globally remain historically low. The large portfolio rebalancing in fixed income was a switch within private sector securities. There was a shift from financial securities into Treasuries, along with non-financial corporate and overseas debt. That is changing as financial institutions are back issuing more and keeping their supply of securities to the market stable.

 

3. Global Growth is not Synchronized – The World is Out of Step with U.S. Monetary Policy

Global growth is accelerating and the OECD estimates that all 46 of the economies that it tracks will see positive growth this year for the first time since 2007². Weak productivity across most of the world is likely to create congestion that would increase inflation  and reduce business investment spending. Since the U.S. currently leads this growth in advanced economies, a U.S. slowdown would have a significant impact on growth in the rest of the world.

The growth in most global economies have been supported by monetary stimulus may be causing some side-effects, including asset bubbles, worsening wealth inequality and misallocation of resources. Persistent low interest rates resulting from monetary stimulus have rolled forward a growing amount of private and public debt to future generations. Technology is deflationary and there are fewer young people able to carry a higher debt burden in the future.

The boost in growth has taken long to materialize and is occurring in the context of muted financial volatility. As we discussed earlier, the recovery still falls short in delivering the high inclusive growth that is needed to deal with a long list of accumulated economic, financial, institutional, political and social challenges.

 

4. Protectionism in Developing Countries

The economics behind the North America Free Trade Agreement (NAFTA) are powerful. Trade is a high priority for the President, who has unilateral executive powers to effect change. Revisiting NAFTA will be an important test of direction for the United States and on their willingness to use trade as a bargaining chip regarding geopolitical tradeoffs.

The United States sells more to Canada than it does to China, Japan and the U.K. combined. Contrary to recent rhetoric, the U.S. currently has a trade surplus with Canada. In negotiating NAFTA, the current list of U.S. demands opposed by Canada includes³:

 

• A “sunset clause” that would automatically terminate the deal in 5 years if all 3 countries did not endorse it again at that time.
• A rule requiring all cars to be made with 50% American content if they are to be exempted from tariffs.
• Dismantling of Canada’s protectionist supply management system for dairy and poultry.
• A “Buy American” procurement policy limiting Canadian and Mexican access to U.S. government contracts.
• The end of the current independent tribunal system for resolving NAFTA disputes.

 

History has demonstrated that when there are trade restrictions, both countries get hurt. Countries are better off to use internal tax policies within their country to deal with the inequality within that country. For the same reason that there is no balanced trade among U.S. states, it is not realistic to strive for it among countries. We will be monitoring developments resulting from NAFTA negotiations as they will have a significant impact on not only Mexico and Canada but the entire global economy.

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

October 19, 2017

 

¹ Scotiabank Global Economics. Scotiabank’s Global Outlook. October 5, 2017.

² BCA Research. Global Investment Strategy. Strategy Outlook Fourth Quarter 2017 Goldilocks And The Recession Bear. October 4, 2017.

³ TheStar.com. Donald Trump’s ‘outrageous’ demands put NAFTA negotiations at risk of collapse as talks resume Wednesday, experts say. Oct 10, 2017.

The Outlook for Interest Rates, the Economy and Inflation in the U.S. and Among the Other Major World Economies

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. What is the outlook for interest rates, the economy and inflation in the U.S. and among the other major world economies?

Beginning with the United States, data indicates that the Fed’s balances sheet may remain substantially higher for longer and that interest rates may remain substantially lower than would have been considered normal before the crisis.

In the twenty years ending 2007, Fed funds averaged 4.85%¹. In September 2007, the Fed started cutting interest rates until it reached 0.25% in December 2008¹. The Fed wasn’t ready to cut further into negative rate territory which left them with an economy needing stimulus while their preferred tool was exhausted. Instead, the Fed embarked in Quantitative Easing (QE), large-scale asset purchases, which dramatically expanded its balance sheet.

Though the Fed has not added to its balance sheet since 2014, it has been reinvesting the interest and principal payments received to maintain the balance sheet at a steady level. Asset purchases as a monetary policy tool is new in the U.S. and allowing the assets to mature may have an unknown affect on the economy.

There is a risk of tipping back into recession if the unwinding begins when growth is too weak. The Fed’s normalization statement pointed out that while it expects to use the federal funds rate to fight recessions, the FOMC may restart reinvestment in the event of substantial interest rate cuts.

After the Fed reduces its balance sheet, rates would likely remain low. The U.S. trend growth rate is believed to be about 2% per year. The FOMC’s poll of its own voting members expects longer-run growth to be in the range of 1.8-2.0%, which is in line with the trend growth rate. For comparison, for 20 years ending 2017, GDP annual growth averaged about 3%¹.

As we discussed in our White Paper 3, the expectation for lower average growth in the years ahead is due to low productivity growth and the aging demographic. The productivity slowdown is a new phenomenon that is not entirely understood and it is possible that productivity acceleration could result in a pick-up in growth eventually. For now, slower trend growth will contribute to lower interest rates in the years ahead than in the period before the crisis. The aging U.S. population is also a factor as increased savings make their way into the fixed income market.

 

Themes

1.  A Mixed World Economic Outlook

Advanced economies grew fairly rapidly in the second quarter, with GDP growth likely to have rebounded strongly in the U.S., Japan and the UK and to have accelerated a little in the euro-zone. This in turn has led to a further reduction in the aggregate unemployment rate in advanced economies. However, there is little sign that wage pressures are rising.

While Japan and the UK saw downward revisions to Q1 growth, the economic growth in the euro-zone was revised up. The euro-zone has now recorded three consecutive quarters of accelerating GDP growth. The recovery in advanced economies as a whole has been driven largely by consumption. Investment spending has also recovered in nearly all major advanced economies, but particularly in the U.S. and euro-zone. Industrial production has generally expanded at a decent pace in recent months. Among the emerging economies, China growth edged up in May for the first time this year.

A synchronized shift in monetary policy swept across bond markets in June with hawkish central bank chatter pushing bond yields higher across Canada and Europe. These moves spilled over to the U.S. bond market despite the slow-moving Republican agenda, soft economic results, and muted pricing pressures.

Global monetary conditions remain loose despite continued tightening by the U.S. Fed. Policy rates in major advanced economies are still exceptionally low. Policymakers in the ECB, Bank of England and Bank of Canada made comments prompting a sell-off in bond markets towards the end of the quarter, but the increase in bond yields was small compared to the move after the election of Donald Trump.

Growth in lending to firms has been steady in the euro-zone, at about 2% year over year². However, there are big differences within the region with lending still contracting in Italy, reflecting the weakness of its economic recovery and the country’s troubled banks.

The Bank of Canada shows confidence in the Canadian economy by raising rates by 0.25% to 0.75% in July and signalling further removal of policy stimulus in the future. Canada has been a leader of major changes in the global monetary system in the past. In 2015, its rate cuts helped kick off a global trend that saw countries accounting for almost half of global output including China, Denmark, Sweden, Indonesia and Australia. Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to over 3% over the past four quarters³.

The Bank of Canada highlighted in its statement that the recent economic data has bolstered their confidence in the “economic outlook for above-potential growth and the absorption of excess capacity in the economy.⁴” Low borrowing costs are fuelling housing prices and household debt is hovering at record levels. Similar to the United States, the labour market has been strong, with the unemployment rate at the lowest since before the recession. Though inflation has not increased, the Bank determined that recent softness in inflation is only temporary and that it will rebound.

The collapse of oil prices that trimmed $60 billion annually off Canada’s national income prevented the Bank from following the Fed in raising rates beginning 2015³.

The Canadian economy appears to be on the verge of a slowdown due to housing-related weaknesses, which is reinforced by higher household borrowing costs. The surging Canadian dollar over the past month as the U.S. dollar weakened would also add to the shift to tightening. The same questions around stagnant inflation apply in Canada and elsewhere.

 

2.  U.S. Growth Slows:  Delayed Fiscal Stimulus and America Alone

Sentiment in the United States economy contradicts recent economic data. While businesses and consumers are positive about the future, economic activity has not been coming in strong. Several surveys report that chief executive officers are highly optimistic, however, M&A activity is at its lowest level since 2013, and has fallen 40% in the past two years⁵.

Share buybacks has slowed and capacity usage has fallen, both indications that CEOs are less confident in the future of their businesses. The University of Michigan’s Surveys of Consumers show confidence at the highest levels since before the crisis. Meanwhile, retail sales fell in May and have been relatively lackluster for the year so far⁵.

The drop back in core PCE inflation to a 17-month low of 1.4% in May has led to expectations that the Fed will hold on raising interest rates⁶.

The Fed’s 2% inflation target looks more like a ceiling since core PCE inflation has only exceeded that level 24% of the time since 1995⁶. Core inflation has been above target only 6% of the time since the target was adopted in 2012⁶.

As we discussed last quarter, a fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year.  The reality is that only a small fraction of the five million lost jobs could conceivably return since China’s shift 15 years ago to largest importer to the WTO. Additionally, assuming the U.S. becomes more aggressive in initiating disputes at the WTO, other countries could retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.

 

3.  Global Low Yield Environment Ends Unevenly

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. The U.S. reflation trade has been delayed by muted wage growth and uncertainty about fiscal policy, but the prospect of ECB normalization is now pushing global yields higher.

The biggest impact of globalisation on interest rates driven by inflation has come through the deflationary effect on traded goods prices, particularly durable goods prices, which have been declining since the late 1990s.

The flattening of the Phillips curve is usually attributed to globalisation, well-anchored inflation expectations, the decline in union power and increases in labour flexibility. This is a global phenomenon. In addition to the United States, low unemployment rates in the UK, Germany, Japan and Canada have failed to spark any meaningful acceleration in either wage growth or core price inflation. Globalisation has undoubtedly played a key role, particularly the entry of China into the global economy.

While China has been an integral part of the global trading system for more than a decade now, the rate of decline in goods prices shows no signs of easing. As a result of globalisation, goods prices now tend to be driven by global economic factors, as much as domestic U.S. factors, which contributed to the flattening of the Phillips curve. However, globalisation and technical progress have had a much smaller impact on services prices.

The rate of service price inflation fell sharply during the 1980s and early 1990s, but that was mainly due to better anchoring of inflation expectations, as the Fed built its credibility as an inflation-fighting central bank. Since the mid-1990s, services price inflation has been more stable. Most recently, housing and other services inflation has been accelerating as expected given the gradual elimination of slack in the labour market. However, health care price inflation has continued to trend lower, which accounts for almost 20% of the core PCE⁶. This explains why core PCE inflation appears to have reacted less to shifts in the output gap in recent years.

 

4.  U.S. Dollar Depreciation

The US dollar has continued to depreciate on a trade-weighted basis in recent weeks, despite another increase in the federal funds rate. It is now around 5% lower than its value at the turn of the year. In June, it fell against all major advanced-economy currencies except the yen. We expect this to continue as the implications of the United States no longer leading in coordinating global trade and climate change, and as fiscal stimulus is delayed due to political headwinds are factored into the currency price.

With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 15, 2017

 

¹ ETF Trends.com, Fed Outlook H2 2017, July 7, 2017.

² Capital Economics. Global Economics Chart Book. July 6, 2017.

³ Bloomberg.com. Your Guide to the Bank of Canada’s Bellwether Rate Decision. July 12, 2017.

⁴ Capital Economics. Canada Rapid Response. July 12, 2017.

⁵ Bloomberg.com. Why Americans Feel So Good About a Mediocre Economy. June 26, 2017.

⁶ Capital Economics. US Economics Weekly. July 7, 2017.