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October 2017

In October, we changed our outlook to Growth for the next three months, reverting back to Stagnation for the following nine months. The economic expansion in advanced economies seems set to continue for the next year, led by rising household consumption and business investment. Although most economies are approaching full employment, inflation has remained below targets.

The ECB is likely to taper its asset purchases during 2018 and raise rates to around 1% by the end of 2019. Inflation is likely to remain below the ECB’s target. Prospects for emerging economies have improved, as Brazil and Russia have come out of recession. China’s economy is likely to slow gradually. In Australia and New Zealand, GDP growth is steady however, inflation remains very weak. We expect the Reserve Banks of both countries to hold rates until 2019.

Having raised interest rates twice this year, we don’t expect the Bank of Canada to move again this year. The economy is benefiting from a rise in business investment and exports, however, there is a risk of downturn in consumer spending next year as household debt weighs and house prices may start to fall.

The U.S. Fed is expected to continue to unwind QE slowly while raising rates. After a slow start to this year, the economy benefitted from looser financial conditions, as bond yields and the dollar have fallen. Since the relationship between spare capacity and inflation has weakened since the financial crisis, average earnings growth should remain very subdued. The recent economic growth was driven by consumer spending and business investment, while exports contributed meaningfully on the back of a softer dollar and firming global demand. The Fed is likely to look through any storm-related economic weakness and seems commitment to one more rate hike this year.

Yields rose during September, with the 10-year Treasury increasing to 2.33%¹. The move up in yields resulted in weak bond returns with the S&P U.S. Treasury Bond Index down 0.77% and the S&P U.S. Investment Grade Corporate Bond Index down 0.24%. The search for yield led the increase in the S&P U.S. High Yield Corporate Bond Index, up 0.87%.

During September, U.S. Equities were strong performers, led by the S&P SmallCap 600 Index gaining 7.7%. The S&P Midcap 400 returned 3.9% and the S&P 500 returned 2.1%. The S&P/TSX Composite was up 3.1% with the Energy sector as the top performer gaining 7.7%.

The Eurozone also posted strong gains in Euro terms, with the MSCI EMU Index returning 4.4%, however, recent Euro weakness weighed on gains. The MSCI EAFE Index of developed market companies returned 2.5%. Emerging Markets, measured by the MSCI EM Index, came under slight pressure from a strong U.S. Dollar, as the index dropped 0.3%.

Unlike the strength seen in September, US dollar weakness was a key highlight in 2017. In the third quarter, strong gains were posted by the euro, up 3.4%, British pound, up 2.9%, Brazilian real, up 4.6%, and Canadian dollar, up 4.0%.  The Mexican peso, down 0.7%, and Japanese yen, down 0.2%, slightly depreciated. From the start of the year to September, the US dollar is down 8%. Commodities broadly rallied in Q3 with oil finally joining metals in positive territory. WTI, up 12%, copper, up 9.5%, and gold, up 3.1%, all posted gains in Q3.

In October, we revised our asset allocation, adding currency-hedged exposure to Canadian equities across all models. Asia ex Japan and currency-hedged Australian equity exposure were added to Growth and Aggressive Growth at 5% and 10% each. We reduced 3-7 Year Treasuries in all models and reduced European equities in Growth and Aggressive Growth.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹Treasury.gov. Resource Centre. Daily Treasury Yield Curve Rates.

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. September 29, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros. 

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Q3 2017 Report

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.

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September 2017

In September, we continued with our Stagnation Outlook for the twelve-month forward period. The global economy continues to chug along with the July IMF forecast for global economic growth of 3.5% for 2017 and 3.6% for 2018 looking attainable¹. All 46 countries monitored by the OECD are on a growth track this year for the first time since 2007².

Rising geopolitical risks including North Korean nuclear tests and American hurricanes have contributed to short-term offsets to this optimism. At his Jackson Hole address in late August, European Central Bank President Mario Draghi told the audience that U.S. protectionist policies also pose a serious risk for growth in the global economy.

Global central bank asset purchases, which have totaled almost $2 trillion this year alone, are the best explanation for money flowing into both bonds and stocks. Shifts in growth and central bank policies are likely to sustain flows away from the U.S. dollar and toward the euro and emerging market currencies. The dollar had acquired a premium in late 2014 and 2015 as it became clear that the Fed would be first to engage in tightening policy. At the same time, political turmoil in the Eurozone helped drive investors into U.S. assets in search of higher yields and better growth. The anticipated lower economic growth in the U.S. will not be enough to keep those flows while growth in Europe and emerging markets are much better.

Federal Reserve officials are reviewing their most basic inflation models. Minutes from the July FOMC meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth. The central bank has missed its 2% price goal for most of the past five years.

Sustained loosening of financial conditions is unique to this tightening campaign, driven in large part by persistently strong equity market returns and a weakening dollar. This behavior has confounded markets and Fed officials. Further tightening is coming as the Fed will soon start shrinking its balance sheet. Since 2008, the Fed has been buying assets resulting in about $2.5 trillion of Treasury bonds and $1.8 trillion in mortgage-backed securities on the balance sheet³. The Fed does not plan to sell these assets; however, as the securities mature, it will stop reinvesting the proceeds, with the permitted monthly run-off gradually rising. U.S. 30-year bonds are most impacted by tightening but the lack of inflation coupled with credit contraction creates a scenario of further flattening of the U.S. Treasury yield curve.

During August, investors nervous about North Korea and other geopolitical risks favored the relative safety of bonds, pushing bond yields lower and prices higher. Long duration government and agency bonds outperformed in that environment, while short duration securities underperformed. August results for U.S. Treasuries posted positive returns, as yields tightened across the entire curve. The S&P 500 gained 0.3% in August, outperforming S&P MidCap 400 (down 1.5%) and S&P SmallCap 600 (down 2.5%). Outside the United States, Canadian equities were positive with the S&P/TSX Composite up 0.7%, while the S&P Developed Ex-U.S. BMI was flat and S&P Emerging BMI gained 3%.

In September, we revised our asset allocation in the Conservative and Moderate Growth models while maintaining the Growth and Aggressive Growth models.  The changes reflect our view that we will continue to see a flattening of the U.S. yield curve and an opportunity in the long end of the yield curve.  In both Conservative and Moderate Growth, we eliminated U.S. Mid-Caps and added to long U.S. Treasuries. In Moderate Growth, we also added a portion to the S&P 500.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹IMF. World Economic Outlook. July 23, 2017.

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

³Federalreserve.gov. Quarterly Report on Federal Reserve Balance Sheet Developments. July 26, 2017.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. August 31, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros.

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August 2017

In August, we continued with our Stagnation Outlook for the twelve-month forward period. This outlook is centered on the United States. The pickup in global growth remains on track, a departure from years past when estimates slid lower as the year progressed. The International Monetary Fund (IMF) projects global output to grow by 3.5% in 2017 and 3.6% in 20181. Aggressive central bank actions and escalating tensions in Northeast Asia are risks to this growth.

Following earlier dollar strength that exerted a significant drag to exports in 2015 and 2016, the recent strength of U.S. exports comes from a 7% depreciation of the dollar to August 212. Over the same period the euro has strengthened on increased confidence in the euro area recovery and a decline in political risk.

The IMF has revised down the growth forecast for the United States for 2017 from 2.3% to 2.1% and for 2018 from 2.5% to 2.1%3. The main reason for the revision, especially for 2018, is that fiscal policy may be less expansionary than previously thought. Meanwhile, market expectations for fiscal stimulus have contracted.

Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. The U.S. unemployment rate dropped to a 16-year low of 4.3% in July, though the number part-time workers that would prefer a full-time job remains slightly above its pre-recession level4. Tighter conditions have not led to a big pick-up in wage growth yet. Oil prices have receded, reflecting strong inventory levels in the United States and a pickup in supply.

The IMF revised down its 2017 growth forecast for the United Kingdom on weaker-than-expected activity in Q1. Meanwhile, it has revised up projections for many euro area countries, including France, Germany, Italy, and Spain, where Q1 growth was generally above expectations.

Global equity prices remained strong in July, signaling continued market optimism regarding corporate earnings. The S&P 500 gained 2.0%, outperforming mid-caps and small-caps, both up 1.0%.  The S&P/TSX Composite came in flat as a weaker U.S. dollar continues to boost the price of Canadian exports. The S&P Developed Ex-U.S. BMI gained 3.0% while S&P Emerging BMI was up 6.2%. In a mixed month for European equity investors, the S&P Europe 350 gained 3.2% as Eurozone economic confidence reaching its highest level for a decade.

In developed markets, long-term bond yields rebounded in late June and early July after declining since March. The U.S. Fed raised short-term rates in June, but markets still expect a very gradual path of U.S. monetary policy normalization. As electoral uncertainty reduced in Europe, bond spreads over Germany have compressed sharply in France, Italy, and Spain, firming signs of recovery.

All model asset allocations were revised in August. The weaker U.S. dollar creates opportunity for greater U.S. exports while S&P 500 companies with foreign operations would be negatively impacted by the weaker dollar. Weighing both, we reduced U.S. midcaps by 5% in all models and added that weight to U.S. large-caps. We removed Canadian equities altogether as NAFTA negotiations through the end of September has cast uncertainty over trade between the two countries. We replaced Canada with an addition to 3 to 7-year U.S. Treasuries. The balance includes Europe and some Australia in the Tactical Growth and Aggressive Growth Models. We maintain 10% in 20+ U.S. Treasuries in all models because of uncertainty around a delay in the next rate hike and the looming threat of a government shutdown around the debt ceiling deadline.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

Data Source: Bloomberg

 

[1] IMF. World Economic Outlook Update. July 2017.

[2] Capital Economics.  United States Chartbook. August 22, 2017.

[3] IMF. World Economic Outlook Update. July 2017.

[4] Capital Economics.  United States Chartbook. August 22, 2017.

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July 2017

In July, we continued with our global Stagnation Outlook for the twelve-month forward period. According to the International Monetary Fund (IMF), the World Economic Outlook continues as expected with global output projected to grow by 3.5% in 2017 and 3.6% in 2018.1 At the country level, growth projections are lower for the United States, assuming fiscal policy will be less expansionary than anticipated. Japan, China and the euro area have seen some solid momentum, revising growth upward. Expectations for fiscal support in China have also supported an upward growth revision. Inflation remains generally below targets in advanced economies and has been declining in many emerging economies including Brazil, India and Russia.

Several advanced economies face excess capacity and slowing potential growth from aging populations, weak investment, and slow productivity growth. Projected global growth rates for 2017–18 are below pre-crisis averages, particularly for most advanced economies and commodity-exporting emerging and developing economies. Policy setting should remain consistent with weak core inflation expectations and muted wage pressures.

Long-term bond yields in advanced economies rebounded in late June and early July after declining since March. The U.S. Federal Reserve raised short-term interest rates in June, but markets still expect monetary policy to normalize gradually. Between March and the end of June, the U.S. dollar depreciated around 3.5% in real terms while the euro strengthened by a similar amount on increased confidence.

Canadian GDP has been outpacing other G7 countries in 2017, with full-time employment rebounding sharply and macro momentum remaining positive. The Bank of Canada raised interest rates in July and WTI stabilized around US$45/bbl. The Canadian Dollar has risen to US$0.80, a 10% rebound from its low in May of US$0.73.2 It appears that Canadian sentiment has improved in response to a shift toward hawkish policy.

U.S. equities posted positive returns in June with the S&P 500 up 0.6%, S&P MidCap 400 up 1.6% and S&P SmallCap 600 3.0%. Canadian equities continued to decline in June as macroeconomic fears, an overly dovish Bank of Canada, and sliding oil prices prompted investors to exit. Global equity markets were mixed in June with the MSCI EAFE Free returning -0.8% and MSCI Emerging Markets gaining 1.6%.

The S&P Europe 350 posted a loss of 2.5%, its biggest monthly decline since the U.K. voted to leave the European Union. The S&P United Kingdom Index dropped 2.5% for the month, contributing significantly to the losses in the broader index as the U.K. represents about a quarter of the S&P Europe 350. Mixed messages coming from both Mark Carney and Mario Draghi resulted in a bond sell off. Commodities ended June in negative territory, with the S&P GSCI down 2%.

In July, we reviewed our current asset allocation across all models and concluded that the current asset allocations remained the most optimal. U.S. Equity exposure for all models remains in mid and large caps with exposure to Canada and Europe making up the balance along with exposure to Australia in the Tactical Growth and Aggressive Growth Models. We continue to hold a 10% exposure across all models in the 20+ U.S. Treasury Bond as we anticipate the Fed move to start reducing the balance sheet. This reduction represents policy tightening and is expected to flatten the yield curve and bring down 10+ year yields, driving up the long end of the curve.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO

Data Source: Bloomberg

 

[1] IMF. World Economic Outlook Update. July 2017.

[2] Capital Economics.  Canada Economics Weekly.  July 28, 2017.

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Q2 2017 Report

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.

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June 2017

In June, we continued with our global Stagnation Outlook for the twelve-month forward period. Although growth was lower than expected in Q1 in several G7 economies, a slow expansion is now well established across the board. That said, some of these economies have made a much better recovery from the crisis than others.

The European Central Bank’s dovish policies have depressed the value of the euro and boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result, wages in central Europe are rising and inflation is accelerating.1

Meanwhile, global core inflation, which has remained stable at a 2% pace in recent years, also slipped this quarter to an estimated 1.7%, raising concerns that it will be more difficult to lift inflation back toward central bank targets.  The recent downshift in China has been a source of concern particularly as it has been mirrored across Asian industry. Global credit conditions remain supportive despite a slowdown in the United States. The latest data on bank lending point to downward pressure on GDP growth in advanced economies, although the slowdown in credit growth has been concentrated almost exclusively in the United States.

After a disappointing 1.2% annualised gain in Q1, U.S. GDP is on track to rise in the second quarter. Industrial production has rebounded in recent months, helped by the continued turnaround in activity in the mining sector. After hitting a 5-year high of 2.7% earlier in 2017, headline CPI inflation has fallen back to 1.9%, due mostly to the recent decline in energy prices.  Core inflation has also slowed in recent months with the annual rate falling to 1.7% in May and the 3-month annualised rate plunging to a 7-year low of zero. There is widespread weakness in core inflation. Despite the Fed raising interest rates again in June and reiterating its plans to continue gradually tightening policy, it appears that markets are pricing in only one 25bp rate hike by the end of 2018. The 10-year Treasury yield has declined even though there were three rate hikes since December last year. The dollar has also continued to decline, with the Fed’s trade-weighted dollar index having now completely reversed its prior surge following last November’s presidential election. Furthermore, the stock market has continued to weather the Fed tightening.

The month of May saw mixed results across U.S. equities. The S&P 500 gained 1.4% while S&P SmallCap 600 lost 2.1%. International equity markets performed well as the S&P Europe 350 gained 4.9%, S&P Asia 50 gained 4.8% and S&P Emerging BMI gained 1.7%. Meanwhile in Canada, the S&P/TSX Composite lost 1.3%. U.S. fixed income markets were positive in May. Municipal bonds were the top performer with the S&P National AMT-Free Municipal Bond Index returning 1.4%. Commodities ended May poorly with the S&P GSCI losing 1.5%. The combination of the lukewarm investor response to OPEC extending its restriction on production and the news that a rise in Libyan output had increased production among OPEC countries for the first time this year sent the S&P GSCI Crude Oil index down 2.8%.2

We rebalanced in June to reflect our continued Stagnation outlook. Across all models, we replaced U.S. Small Caps with U.S. Large Caps in response to the postponement of corporate tax reform that is now better reflected in Large Cap valuation. We maintained Canadian and European Equity exposure as well as the long-term U.S. Treasury Bond. Financial conditions appear more accommodative since late last year due to lack of evidence of inflation in the U.S. despite Fed rate hikes. Our shift to long bonds reflects our view that this may not reverse in the near-term. For more insight into our views on the changing impact of inflation, see our most recent White Paper: A Regime Change Underway, available on our website.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

 

[1] BCA. Emerging Markets Strategy – Central Europe: Beware of An Inflation Outbreak (Special Report), June 21, 2017.

[2] Index Returns: S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. May 2017.

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May 2017

In May, we continued with our global Stagnation outlook for the twelve-month forward period. The outlook for the world economy is improving and world trade has picked up. Manufacturing conditions in advanced economies are improving and point to a rebound in economic growth in Q2.

The recovery in the euro-zone has gained momentum after being captivated by the closely-fought first round of the French elections in April and the second round on May 7 that brought considerable relief. The flash composite PMI for the euro-zone stayed at its highest level in six years and the composite PMIs for Germany and France reached six-year highs1.  As the remaining European Union nations present an increasingly unified front ahead of the upcoming “Brexit” negotiations, the medium-term economic outlook for the U.K. weakened while the prospect of a big win for Theresa May’s Conservative party in a general election slated for June 8th helped the British pound strengthen.

The U.S. looks set to hold back from extreme protectionist policies, and any changes to NAFTA seem slow to materialize. Although the Trump administration claims that external trade is a drag on economic growth, for the past five years the monthly trade deficit has been broadly unchanged in dollar terms. That said, the goods trade deficit widened slightly in April, as exports declined by 0.9% m/m and imports increased by 0.7% m/m2. The decline in exports was driven by a 7.5% m/m slump in automotive exports and a 4.5% m/m fall in consumer goods exports3.

The slowdown in Q1 GDP growth to just 0.7% annualized resulted from lower government spending and inventories4. Investment spending added 1.7% to growth, its largest contribution in five years5. The recent weakness in inflation and the political dysfunction that threatens to delay tax reform have resulted in only a modest decline in interest rate expectations. Monetary policy looks set to diverge from other major economies as the U.S. Fed continues to prepare investors for future rate hikes. Headline CPI inflation remains elevated, yet core inflation was unexpectedly weak in both March and April, bringing the three-month annualized core inflation rate to a six-year low of only 0.6% in April6.  The headline unemployment rate declined to a 10-year low of 4.4% in April, a level that would typically cause the Fed to behave hawkish7. However, wage growth remains at a low of 2.5% year over year8.

U.S. Equity markets were positive this month with the S&P 500 gaining 1.0% and S&P 600 Small Cap gaining 0.9%. International equity markets performed well in April with S&P Developed Ex-U.S. BMI and the S&P Emerging BMI both up 2%.

April results for U.S. fixed income returned to positive territory, with the S&P Preferred Stock index as the top performer, up 1.2% for the month. All the aggregate’s components had positive returns; S&P Taxable Municipal Bond Index up 0.9%, and S&P Investment Grade Corporate Bonds up 1.2%. The S&P U.S. High Yield Corporate Bond Index returned 1.1% for April.

Commodities performed poorly, driven by continued weakness in Energy, while the current increased level of geopolitical risk resulted in gold prices benefiting from the asset’s status as a safe haven.

We rebalanced the portfolio models in May to reflect our continued Stagnation outlook. Across all models, we lowered exposure to U.S. Small Cap and Canadian Equity, added to European Equity and a new position in Long-term U.S. Treasury Bonds. Financial conditions have become more accommodative since late last year, even though the Fed has hiked its policy rate twice during that time and our shift in the direction of long bonds reflects our view that this will not be unwinding in the near-term.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

[1] Capital Economics, Global Economics Data Response. May 23, 2017.

[2] Capital Economics, US Rapid Response. May 25, 2017.

[3] Capital Economics, US Rapid Response. May 25, 2017

[4] Capital Economics, United States Chart Book. May 17, 2017.

[5] Capital Economics, United States Chart Book. May 17, 2017.

[6] Capital Economics, United States Chart Book. May 17, 2017.

[7] BLS.gov

[8] BLS.gov

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April 2017

In April, we continued with our global Stagnation outlook for the twelve-month forward period. After a lackluster showing in 2016, economic activity in emerging and developing economies is projected by the International Monetary Fund to pick up the pace in 2017 and 2018. There is a wide dispersion of possible outcomes, however. Persistent structural problems such as low productivity growth, binding structural impediments and existing policies are increasing in advanced economies. These threaten global economic integration and the cooperative global economic order that has served the world economy in both emerging market and developing economies.

A long-awaited cyclical recovery in global manufacturing and trade is underway. The IMF predicts that world growth will rise from 3.1% in 2016 to 3.5% in 2017 and 3.6% in 2018. Eurozone economic data has been encouraging so far, and the uptrend in capital goods orders bodes well for investment spending. Private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. The unemployment rate has fallen and there is less spare capacity in European labor markets today than when the U.S. Fed first hinted at tapering its asset purchases in 2013. Other encouraging data shows the outlook for France is improving despite uncertainty about the outcome of the presidential election there.

In the United States, manufacturing activity has been strengthening in recent months, largely because the drag from the past appreciation of the dollar has faded. Prospects for stimulative tax cuts and infrastructure spending, along with the fears of blowing out the budget deficit, all seem to have been pushed further back in the time horizon for the U.S. economy. The decline in core consumer prices in March, the first monthly fall in seven years, may be a signal of underlying weakness in the real economy. The key message from the March Fed meeting may be at odds with this trend, as they now believe that inflation has finally reached its 2% target.

U.S. equities were flat in March as the S&P 500 gained 0.1% and S&P SmallCap 600 declined by 0.1%. The S&P 500 dispersion recorded its second-lowest monthly reading for a decade1. The present low dispersion coincides with lower correlation and much lower benchmark volatility than in July 2011, the last time dispersion was this low. Similar trends are seen globally, with low benchmark volatility, moderate-to-low correlations, and low dispersion. U.S. Small Caps and Latin America are exceptions to this trend, while Japan’s equity market continues to show higher correlation than its peers.

The Fed’s announcement of another interest rate hike negatively affected most fixed income sectors. March results for U.S. fixed income were flat or negative, with the broad S&P U.S. Aggregate Index down 0.04% for the month.  Mortgage backed securities and Preferred bonds posted positive returns for the month. Outside the U.S., International equity markets performed strongly in March.  Canadian equities were positive, with the S&P/TSX Composite TR Index up 1.3%. In Europe, the S&P Europe 350 TR gained 3.4%. The MSCI United Kingdom increased 1.7%. The European Central Bank’s hawkish tone at its March meeting indicated that tighter monetary policy was coming, causing most European bond indices to fall in March.

We rebalanced the portfolio models in April to reflect our continued Stagnation Outlook, while factoring in the relative opportunities in International Equities.  We reduced U.S. Mid Caps and Small Caps in all models. Exposure to Australia was eliminated in the Conservative and Moderate Growth models and reduced in the Growth and Aggressive Growth Models, as the early March positive revision from the IMF benefited the Australian equity market disproportionately relative to Europe. Exposure to Europe was initiated in the Conservative, Moderate Growth and Growth models and increased in the Aggressive Growth portfolio.  Exposure to fixed income was increased across all models including reinitiating exposure to Municipal Bonds in the Aggressive Growth portfolio model.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

[1] S&P Dow Jones Indices.  Index Dashboard: Dispersion, Volatility & Correlation.  March 31, 2017.

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Q1 2017 Report

When does inflation begin to change investment decisions?

During the first quarter of 2017 we removed U.S. inflation from our outlook and reverted to Stagnation for all global economies for the twelve-month forward forecast. Looking to the future, our analysis suggests that ongoing monetary accommodation is unlikely to have significant inflationary consequences, if inflation expectations remain anchored. As we enter the second quarter of 2017, we are redefining our Inflation environment to U.S. CPI1 greater than 3.5%, up from the previous 2.7%. We will review this as the economy grows, and as underlying inflation and interest rates move higher.

With U.S. macro data coming in strong and further evidence that price pressures are building, the uptrend in bond yields appears likely to continue.  As the focus of rising yields is primarily to manage the rate of growth of an economy and inflation, we believe it worthwhile to review the traditional and current relationships between growth, productivity, inflation, bond yields and equities. The recent rising trend in bond yields has been positively correlated with continued gains in equities, which we relate to a low inflation environment.

Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. From a longer-term perspective, real interest rates have been on a steady decline over the past three decades. Despite recent signs of an increase in long-term yields, particularly in the United States, the experience of Japan suggests that an exit from a low interest rate environment does not come with a play book. A combination of slow-moving structural factors, including population aging and slower productivity growth currently plaguing many advanced economies, are generating a steady state of lower growth and lower nominal and real interest rates in these countries. With the second Fed hike in December and the expectation that the Fed will soon begin to shrink their bond portfolio, the market will judge whether the tighter financial conditions will impact growth. Challenging the impact of the rate hike is the impact of the stronger U.S. dollar.

U.S. Payroll employment started the year on a strong note, with monthly gains in both January and February well above 200,0002.  Rising labour costs helped drive core inflation above 2% but these costs are rising faster than selling prices in the non-financial corporate sector.  Is the U.S. economy growing fast enough to support higher interest rates?

Expansion of central bank balance sheets has produced a multiplier effect on U.S. equity returns. This has impacted confidence which fed into soft data, namely business and consumer confidence, the measures of expected growth for the U.S. economy and inflation. Hard data, such as payrolls and industrial production, have not been as encouraging. The gap between “hard” and “soft” data measuring the U.S. economy has never been wider3.

 

Rising Yields from Low Levels Remain Friendly for Equities

A slowdown in productivity tends to be deflationary at the outset and inflationary later. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households absorb smaller real wage gains. Stabilization of inflation may imply a shift in economic volatility to other variables, helping generate asset-price booms by making borrowing and risk-taking more attractive. It may also raise the return to capital by restraining wage growth.

 

There is good reason to question the view that lower unemployment will push wage growth substantially higher in the current environment.

 

 

Such results could be explained by the fact that in a very low yield environment, higher yields are perceived as an indication that the economy is improving, which also benefits equity prices. Central banks have debated what the inflation target should be. The first inflation target was adopted by the central bank of New Zealand in 1990. The Fed used an unofficial inflation target until January 2012, when it announced that it thought a policy which targets a 2% rate of inflation is consistent over the longer run with the Fed’s mandate4.  Looking ahead, three structural forces look set to keep us in this low yield environment over our forecasting time horizon of the next twelve months; technical change, flexible labour markets and globalization. We examine this question in further detail in our third Whitepaper available on our website.

 

How should the Fed respond?

Two Federal Reserve Board economists, Michael T. Kiley and John M. Roberts, suggested three ways for the Fed to avoid zero interest rates as much as possible5. We prefer their suggestion to set the inflation target above 2% with the Fed keeping an eye on the weighted impact of all capacity constraints currently present. This is based on our recent conclusion that structural forces will prolong the deflationary forces currently in play.

Headline inflation in the developed world is likely to rise in early 2017, due largely to rising oil prices and a generally firmer global backdrop. Underlying inflation would rise slower as above-trend growth eats away at available slack. Interest rates will likely remain low in many economies, and will not rise substantially in the U.S. in the coming years.  A year ago, a drop in aggregate demand caused a decline in global goods prices.  Stimulus from the BOE, ECB and BOJ was used to fight this trend and contributed to growth.

The recent rebound in inflation is attributed to previous falls in oil prices, a process which has now almost finished. Long-term inflation expectations pulled back in most advanced economies over the past month while headline CPI inflation in major emerging economies continued to fall in February. Emerging markets still struggle while bigger economies are stabilizing.

We conclude that pressures on productivity and demographics will keep inflation pressures and growth in the U.S. and globally at levels within our Stagnation Environment definition for a period extending well beyond our twelve-month forecast horizon.

 

Themes

1.  A Brighter World Economic Outlook

The world economy has entered Q2 in better shape than it exited 2016. It has now been confirmed that global GDP growth accelerated in each quarter of 2016 and was close to 4% in Q4. However, there is still notable divergence in performance among G7 economies. The United States, U.K. and Germany grew by an expected 2% annualized in Q1, while France and Italy are expected to have grown at around half that pace.  In the euro-zone, production grew by nearly 1% in January, and industrial output in Japan has surged over recent months.  The latest output data for the major emerging economies have been mixed. GDP trackers point to a renewed downturn in Russia while information out of China suggests that the improvement in growth seen over the past year or so has fizzled out.

Headline inflation has rebounded in every major economy. In developed markets, monetary easing is on it’s way out while emerging market central banks plan to continue cutting their policy rate.  Among central banks this year, 13 have cut their interest rates while five have raised them6. The unweighted global average policy rate dropped below 2%, an all-time low, while world inflation jumped to 2.5% due to energy prices, resulting in negative real global policy rates7.

The unemployment rate in the OECD fell to 6.1% in January, its lowest since 20088. Employment growth has slowed in the U.K. in recent months, but has continued at a steady pace elsewhere. Euro-zone employment has finally recovered to levels seen prior to the global financial crisis.

The IMF published its twice-yearly health check on the world economy. The outlook has brightened considerably since an interim forecast in January. Signs of stronger activity are visible in both developed and emerging markets. Forecasts for worldwide GDP growth are expected to be revised upwards.  Christine Lagarde of the IMF recently noted that after six years of disappointing growth, the world economy has a “spring in its step”. The outlook could be revised because of political uncertainty (Marine Le Pen might win in France), protectionism (Donald Trump might start a trade war) and tighter global financial conditions (the Fed might raise interest rates too quickly).  For the first time since the recession, there are a lot of things going well.

 

2.  U.S. Growth

The latest data indicate that first-quarter GDP growth was relatively subdued at 2% annualised. That said, a lot of the weakness can be traced back to a sharp drop in utilities demand stemming from the unseasonably mild winter. The sudden post-election weakness in bank lending is a concern. Most of the market and media attention has focused on business loans which, after growing at a double-digit annualised pace between 2014 and late 2016, have suddenly stagnated while other major loan categories also show a marked slowdown in growth since last November.

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 jobs lost since China’s shift fifteen years ago to largest importer to the WTO could conceivably return. Also, assuming the U.S. becomes much more aggressive in initiating disputes at the WTO, we would expect other countries to 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.

Changes to U.S. fiscal policy are not expected to take effect this year, eliminating their potential boost to growth. The combination of proposed fiscal stimulus and higher trade barriers in 2018 will likely add to inflation expectations but this may be offset by changing technology, labor markets and unstoppable globalization.  American companies with large global footprints will suffer relative to domestically focused firms. We have positioned for this change by emphasizing small caps at the expense of large caps with our U.S. equity exposure. Small caps are traditionally domestically geared irrespective of their domicile. U.S. small caps face a potential additional benefit if the new administration follows through with promised corporate tax cuts.  Small caps would benefit disproportionately given that the effective tax rate of multinationals is already low.

 

3.  The Low Yield Environment Prevails

At its March 2017 meeting, the FOMC voted to raise the federal funds rate, the second increase since 2008’s financial crisis. However, the rise in government yields came to a halt after the FOMC talked back the future pace of hikes causing investors to scale back their expectations.

At the same time the continuing accommodative approach to monetary policy outside of the U.S. and the stronger U.S. dollar will likely lead to more foreign buying of U.S. Treasuries.  This would bid up prices and drive down yields, a headwind for the Fed.

 

4.  Monetary Policy

Historically, changes in real interest rate differentials have been the dominant driver of currency

movements in developed economies. In addition, growth in the dollar value of trade has been stronger, buoyed by higher commodity prices. Monetary policy expectations between the Fed and other G7 central banks should keep the US dollar strength in place.  A stronger dollar is both a blessing and a curse for margins. All else equal, it lowers the cost of imported goods and thereby boosts margins for import-intensive firms, while undermining profits earned overseas.

With 44% of S&P 500 revenues generated outside the U.S., the net impact of dollar strength is negative for overall corporate profits. Stronger growth is required to offset the negative impact on profits from a rising dollar.

 

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

 

[1] Inflation measured by Consumer Price Index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.

[2] Capital Economics. Non-farm payrolls rise 227,000 in January and 235,000 in February.

[3] FT.com. Morgan Stanley flags ‘record gap’ between hard and soft US economic data.

[4] The Economist. Why the Fed targets 2% inflation.

[5] Kiley, Michael T. and Roberts, John M. 2017. “Monetary Policy in a Low Interest Rate World.”  Brookings Papers on Economic Activity. BPEA Conference Drafts, March 23–24, 2017.

[6] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[7] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[8] OECD Harmonized Unemployment Rates. News Release: January 2017.  Paris, 9 March 2017.

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