The role of the financial industry as an allocator and distributor of capital to the economy is critical to the evolution of the current pandemic. The current health crisis has morphed into an economic crisis, which has morphed into a financial crisis. While advances in testing and contact tracing will help, risk of a second wave of infections and the re-imposition of strict containment measures is likely to remain until a vaccine is developed. Simultaneously, geopolitical risks are heating up amid escalating tensions over Hong Kong, civil unrest in the U.S. and the return of Brexit uncertainty. We are monitoring these developments and have maintained our previous Recession outlook for the U.S. economy to reflect a Recession that began in March and extends through the end of the year.

Central banks globally have taken action. The China National People’s Congress (NPC) has laid out plans for fiscal stimulus. Japan’s fiscal support measures turned out to be larger than initially planned, at 22% of GDP.1 The European Central Bank announced €750B in stimulus grants and loans to be funded by the currency area’s first joint debt.2 The 17.1% month over month collapse in eurozone industrial output in April was partly reversed in May and June, but the recovery will be much more gradual than the slump.3 In the U.K., GDP figures for April showed that output fell by a cumulative 25% since its pre-crisis peak in February.4

The FOMC minutes reinforced the Fed’s commitment, putting floors on risk markets. The Fed has moved to the outer limits of monetary intervention to backstop CMBS, investment grade bonds, the muni market, and high yield debt. The Fed’s balance sheet has expanded more in three months than it did cumulatively in the six-year period from December 2007 to November 2013.5 The U.S. international trade deficit widened to $49.4 billion in April as exports slumped.6 The closure of motor vehicle production plants throughout North America had the greatest impact on the slump. Retail sales plummeted in April, down 16.4%, a 21.6% year-over-year decline but began to recover in May (up 17.7%) as thousands of stores and restaurants reopened after lockdowns and federal stimulus checks and tax refunds fueled a burst of spending.7 The permanent devastating impact on the economy can be seen in retail bankruptcy filings, as retailers J.C. Penney, J. Crew, and Neiman Marcus declared bankruptcy, and Lord & Taylor plans to liquidate.8 Unemployment was 14.7% in April, followed by an improvement in May to 13.3% as 2.5 million jobs were added back to the nonfarm employment.9

Statistics Canada announced that the services trade balance jumped from a deficit of $1.1 billion in March to a surplus of $0.3bn in April, reflecting that more Canadians travel abroad than foreigners travel to Canada.10

Markets during May were driven by some positive data and reopening plans. The S&P 500 closed up 4.8% for the month. The S&P MidCap 400 gained 7.3% and S&P SmallCap 600 gained 4.3%. Canadian equities had a positive month, with the S&P/TSX Composite up 3.0%. S&P Europe 350 gained 2.9% as contributing nations unlocked at differing speeds with German equities providing the greatest positive contribution. Asian equities continued their recovery, with the S&P Pan Asia BMI up 3.0%. S&P China 500 gained 1.0%, S&P Korea BMI was up 4.8%, while S&P Hong Kong BMI dropped 7.8% in May.

In June, we maintained the asset allocation that was established in May for all portfolio models. We continue to be positioned in shorter duration fixed income. We expect interest rates to remain low or negative across the globe and as a result, we continue to have exposure to gold which is a store of value in this environment and a preferred asset for central banks for the foreseeable future. Equity exposure to large cap across all models reflects our view that shifting business models during this pandemic have had a negative impact on bottom lines but that select businesses are benefiting from the shift.

The scale of the economic damage caused by the coronavirus outbreak will lead to an extended period of weak economic growth, excess capacity, deflationary pressure, and a wave of bankruptcies. Financial repression is likely to remain through our outlook time horizon (the next twelve months) as central banks continue to demonstrate their willingness to keep widening their safety net. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. 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

 

1KPMG Insights, Japan. April 7th, 2020.

2European Central Bank. March 18th, 2020.

3Trading Economics, Eurozone Industrial Production. April 2020.

4Trading Economics, United Kingdom GDP Growth. May 13th, 2020.

5Trading Economics, U.S. Central Bank Balance Sheet. June 10th, 2020.

6Trading Economics, U.S. Balance of Trade. June 4th, 2020.

7Trading Economics, U.S. Retail Sales. June 16th, 2020.

8S&P Global Market Intelligence. May 15th, 2020.

9Trading Economics, U.S. Unemployment Rate. June 5th, 2020.

10Trading Economics, Canada Balance of Trade. June 4th, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. May 29, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The economic impact of the extraordinary measures taken by governments all around the world to flatten the COVID-19 pandemic curve is highly uncertain. The outcome will depend on the evolution of the virus and the intensity and efficacy of containment efforts. Economic data continue to show severe economic disruptions associated with COVID-19 and only limited signs of a recovery so far. The dichotomy between the supply and demand side is concerning as evidenced by the re-opening of some economies where consumers remain on the sidelines. Central banks are now operating at the limits of what they can do to support aggregate demand. Consequently, we are entering an era of more active fiscal policy. We are monitoring these developments and have maintained our previous Recession Outlook for the U.S. economy to reflect a Recession that began in March and extends through to the end of the year.

Emerging Market central banks are cutting rates aggressively, allowing their currencies to depreciate while supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term but will lead to stronger economic recovery down the road. In China, industrial production rebounded to a 3.9% annual growth rate in April while retail sales remained weak as they contracted at an annual 7.5%1.

In this crisis, the U.S. government is ramping up its deficit much faster and much more aggressively than it did in 2008. A corporate bond-buying program was announced by the Fed in March, as part of a package of pandemic rescue measures. The program, which is managed by BlackRock, will take $75 billion in equity from the Treasury and leverage it 10-to-1, giving it up to $750 billion to buy corporate bonds for the first time in its history, starting with bond ETFs2. On April 8, the Federal Reserve widened the credit ratings of corporate bonds it will buy to include recently downgraded corporate bonds that have a rating no lower than BB-, as well as ETFs that have exposure to eligible non-investment grade corporate bonds3.

The U.S. trade deficit widened in March as a decline in exports outweighed that in imports. The service sector declined, driven by the collapse in international tourism. The April ISM non-manufactur­ing index declined 10.7 points to 41.84. The jobs report showed that U.S. payrolls plunged by 20.5 million in April as the unemployment rate skyrocketed to 14.7%5. The consumption basket of U.S. households has shifted in a way not reflected in the CPI’s basket. People are buying more food from the grocery store, more gym equipment, etc. while not spending money in restaurants and hotels, suggesting that the basket faced by the consumer is experiencing greater inflation than what the BLS measures. In Canada, real manufacturing sales fell 8.3% in March, and Automotive News reported total auto production of zero units in the month of April6. Existing home sales fell by 57% in April7.

After March’s carnage, April offered a welcome rally. The S&P 500 gained 12.8%, the best monthly performance since January 1987. The S&P MidCap 400 was up 14.2% while the S&P SmallCap 600 gained 12.7%. In Canada, the S&P/TSX Composite gained 10.8%. The pandemic is only one of two shocks, the other being global energy prices. This weakness has also been apparent in the Canadian dollar. Northern European equities outperformed, while Southern Europe lagged as politicians squabbled over the form and magnitude of potential relief for the nations hit hardest by COVID-19. The S&P Europe 350 gained 6.1% on the month while the S&P United Kingdom gained 3.5%.  Asian equities began to recover in April, with the S&P Pan Asia BMI up 8.5% while the S&P China 500 gained 6.1%.

In May, we maintained the asset allocation between Equities and Fixed Income but adjusted our exposure within Fixed Income. We added Mortgage Backed Securities while removing Municipal Bonds, the 3-7 year Treasury was added to replace the 7-10 year Treasury, and the 20+ year Treasury was removed with the allocation going to Mortgage Backed Securities and Gold for the Growth and Aggressive Growth Models. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The market is reconciling a deep global recession of uncertain length, with a V-shaped recovery in financial markets supported by an extraordinary central bank back-stop. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. 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

 

Trading Economics, China Industrial Production and Retail Sales. April 2020.

The Federal Reserve. March 23rd, 2020.

The Federal Reserve. April 8th, 2020.

Trading Economics, U.S. ISM. May 5th, 2020.

Trading Economics, U.S. Unemployment Rate. April 2020.

Trading Economics, Canada Manufacturing Production. April 2020.

CREA Monthly Housing Statistics. May 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. April 30, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The economic cost of the COVID-19 crisis may pale in comparison to the human cost. Many people fear for their own health and that of their loved ones. As such, there is a “real” element to the fear factor. Measures to contain the virus have upended supply chains and financial markets and have weighed on commodity prices. Consumer and business confidence are expected to remain subdued for some time, not least if fears of a second wave of the virus linger. We are monitoring these developments and have maintained our previous Recession outlook for the U.S. economy to reflect a Recession beginning in March and extending through the end of the year, as the situation will deteriorate further before beginning to recover.

With lockdowns in place across much of the world, the IMF has downgraded their forecasts further in recent days, now forecasting global real GDP to fall by over 3% this year. That compares with a pre-virus forecast assuming growth of about 3%. This means that 2020 is set to be the worst year for the global economy since the end of the Second World War, when world GDP in 1945 plunged by 5.5%.1

The Fed has launched many new programs. The U.S. was on track for an outright fiscal drag in 2020 due to expiring stimulus, living with the largest fiscal deficit and thus is the least capable of delivering more fiscal stimulus. The Federal Reserve has now expanded its balance sheet beyond $6 trillion, an increase of almost $2 trillion in less than a month.2 It has taken extraordinary steps to lift regulations to help banks play their part in the relief effort. One consequence may be that central bank support could help most risky assets to outperform safe ones by a wide margin as these measures go far beyond conventional monetary easing in their efforts to backstop the financial system. With a policy interest rate that has been cut to a range of 0% to 0.25% and commitment that rates would stay low indefinitely, the supply of funds outside of the Feds own money creation may become scarce. By virtue of a system that promotes superior productivity growth, the country’s knack for nurturing world-beating companies, and less challenging demographics than the developed world, there is some hope that the U.S. can outpace most of the developed world in economic recovery.

Canada will rack up debt faster in this crisis than any other developed country, relative to its economy, according to data from the IMF. It is fortunate that Canada’s governments went into this economic crisis in a much better financial position than most other developed countries. Net government debt (total government debt minus its cash holdings) was at 40% of economic output before the crisis. The average for developed countries was 107%. This may be why Canada’s governments have proven more willing to spend their way out of the crisis than some others.3

Global markets in Q1 were devastated by the coronavirus pandemic. U.S. equities posted their worst quarter since 2008, with the S&P 500 down 19.6%. The S&P MidCap 400 and the S&P SmallCap 600 were down 29.7% and 32.6%, respectively. Canadian equities were likewise battered, with the S&P/TSX Composite down 20.9% for the quarter. The Canadian Energy sector was down by 30.8% in March and 37.2% in the first quarter. The global pandemic fears also spread rapidly across Europe. Italy, and then Spain. The S&P Europe 350 fell 14.0% in March to complete a 22.4% drop this quarter, the worst monthly and quarterly performance since September 2002. International markets were not spared, and the S&P Pan Asia BMI was down by 20% for the quarter. U.S. Treasuries benefited from a flight to safety. Corporate bonds fared less well, as spreads widened across sectors and grades of the credit market.

In April, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.  Allocation to equities was reduced in February to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. In February, within the Fixed Income allocation, we added the 20+ year Treasury Bond. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class. Gold has played an important role in portfolios as a source of liquidity and collateral. As has been the case in previous market selloffs, we have seen that the stronger the pullback in the stock market, the more negatively correlated gold becomes.

This shutdown will cause the greatest short-term drop in output that the global economy has ever experienced, and the pace of the subsequent recovery is hard to determine at this time. No one knows how long the supply and demand disruptions will constrain growth. We will continue to monitor the data for growth, inflation, and recession 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

 

1 Capital Economics. Global Economics Update. March 31, 2020.

2 Capital Economics. U.S. Economic Update. April 16, 2020.

3 National Bank of Canada. Public Sector Debt. April 15, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. March 31, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

 

Section 1: Q2 2020 Outlook

 

Global Risk: The World Is Heading for the Sharpest and Deepest Global Slowdown Since WW2

The economic cost of the COVID-19 crisis may pale in comparison to the human cost. Many people fear for their own health and that of their loved ones. As such, there is a “real” element to the fear factor. Measures to contain the virus have upended supply chains and financial markets and weighed on commodity prices. Consumer and business confidence is expected to remain subdued for some time, not least if fears of a second wave of the virus linger. Given the hit to both the services and goods-producing sectors, the International Monetary Fund (IMF) expects real GDP to contract at a greater than 30% annualized pace in the current quarter.i

This shutdown will cause the greatest short-term drop in output that the global economy has ever experienced, and the pace of the subsequent recovery is hard to determine at this time. No one knows how long the supply and demand disruptions will constrain growth.

Markets are looking for confidence in the policy response. Policy must ensure that households, businesses, and the financial system remain liquid. Policy should also aim to minimize damage to the solvency of all stakeholders, preventing sharp drops in business and household cash-flow positions from triggering a wave of bankruptcies in the real economy and of margin calls in the financial system.

 

Containment and Stabilization Followed by Recovery

With lockdowns in place across much of the world, the IMF has downgraded their forecasts further in recent days, now forecasting global real GDP to fall by over 3% this year.ii That compares with a pre-virus forecast assuming growth of about 3%. This means that 2020 is set to be the worst year for the global economy since the end of the Second World War, when world GDP in 1945 plunged by 5.5%. Most of the output lost in the first half of this year will probably be lost forever and it could take years for demand to recover completely. Demand for travel abroad may stay weak for months and possibly years. Secular stagnation forces, political uncertainty, and empty monetary toolkits indicate that rapid recovery is not possible even after the virus-related supply and demand disruptions have faded. Firms will be considering how to repay their emergency loans, while in some countries there might be the prospect of a new wave of austerity to repay the rise in public debt. Early signs from China are that demand has been slow to return despite firms being told to resume normal operations in February.

This crisis will need to be dealt with in two phases: a phase of containment and stabilization followed by the recovery phase. In both phases public health and economic policies have crucial roles to play. Quarantines, lockdowns, and social distancing are all critical for slowing transmission, giving the health care system time to handle the surge in demand for its services and buying time for researchers to try to develop therapies and a vaccine. These measures can help avoid an even more severe and protracted slump in activity and set the stage for economic recovery.

The new policy mix will require that fiscal policy be used to attain full employment and price stability, while monetary policy will be used to ensure debt sustainability by keeping sovereign yields low. As well as going all-out in its role as lender of last resort, central banks will be required to do the same for the financial system.

So far, the fiscal response in affected countries has been swift and sizable in many advanced economies including Australia, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States. Many emerging market and developing economies, such as China, Indonesia, and South Africa have also begun providing or announc¬ing significant fiscal support to heavily impacted sectors and workers. Fiscal measures will need to be scaled up if the stoppages to economic activity are persistent, or the pickup in activity as restrictions are lifted is too weak.iii

Globally, central banks’ response to the coronavirus crisis has been unprecedented and is likely to change the way that financial markets function for years to come. Countries are starting out with very different fiscal positions. Central banks’ balance sheets will be far larger and contain a much wider variety of assets than before as a result. Germany currently enjoys a budget surplus and has plenty of fiscal capacity, and China is now pumping in substantial support.

The Fed has launched many new programs. The U.S. was on track for an outright fiscal drag in 2020 due to expiring stimulus, living with the largest fiscal deficit and thus is the least capable of delivering more fiscal stimulus. Now the Fed is giving the Treasury access to its printing press. This means that, in the extreme, the administration is free to use its control, to instruct the Fed to print more money so it can buy securities and hand out loans in an effort to ramp financial markets higher. The case for central-bank independence has gone largely unquestioned for years. Logic assumed that politicians think short-term and make decisions for political reasons. At full or close-to-full employment, expansionary monetary policy might briefly juice the economy but, after a delay, create inflation. When monetary policy is kept at arm’s length from politics by making it the responsibility of an independent central bank, you avoid the problem. This logic is now being put to the test.

The Fed’s actions can be split into three main categories. First, it has acted as a “buyer of last resort” in many markets. This covers its open-ended purchases of Treasuries and mortgage-backed securities (MBS), including agency commercial MBS. It also covers its purchases of commercial paper, corporate bonds, and municipal bonds. Though the aim is different, the Fed will also purchase so-called “Main Street” loans. Second, it has lent against all kinds of collateral, either to support key parts of the financial system, or to encourage more lending by other institutions. The Money Market Mutual Fund Liquidity Facility and Primary Dealer Credit Facility are examples of the former. The Term Asset-Backed Securities Loan Facility is an example of the latter. That facility lends against asset-backed securities (whose underlying exposure is to a wide variety of loans including auto loans and leveraged loans), aiming to boost issuance. Third, it has acted to limit financial distress outside the U.S., and the associated upward pressure on its currency, by making cheap dollar funding readily available. This covers the Fed’s revived and expanded swap lines, plus its new Foreign and International Monetary Authority (FIMA) repo facility.iv

The Federal Reserve has now expanded its balance sheet beyond $6 trillion, an increase of almost $2 trillion in less than a month. It has taken extraordinary steps to lift regulations to help banks play their part in the relief effort. One consequence may be that central bank support could help most risky assets to outperform safe ones by a wide margin as these measures go far beyond conventional monetary easing in their efforts to backstop the financial system.v With a policy interest rate that has been cut to a range of 0% to 0.25% and commitment that rates would stay low indefinitely, the supply of funds outside of the Feds own money creation may become scarce. By virtue of a system that promotes superior productivity growth, the country’s knack for nurturing world-beating companies, and less challenging demographics than the developed world, there is some hope that the U.S. can outpace most of the developed world in economic recovery.

 

Controlling Our Own Behavior it the Middle of a Pandemic

In the middle of this global pandemic, we consider what we can and cannot control. This applies not only to our individual behavior, but also when it comes to our investment positioning.

In theory, being prepared for a low-probability, high-consequence event such as a pandemic is possible. Identify threats. Consider how to mitigate. Weigh costs of mitigation against probability and consequence, factoring in available resources and competing demands. Prepare.

An economist describes loss aversion as when an individual’s utility is concave over gains and convex over losses. This means that a gain contributes less to utility/happiness than an equal dollar loss subtracts from utility/happiness. The current economic meltdown presents us with the reality that when a capital loss is suffered, ability to recover the same amount that was lost must be done from a lower base, requiring a larger percent recovery just to break even. This pain is not imagined, it is very real (see our White Paper at www.frameglobal.com/education). Avoiding losses in the first place is much preferred to recovering from losses.

 

We Put Economic Theory into Practice and Have Been Rewarded

Frame Global Asset Management considers the outlook for the global economy relative to a view of expected U.S. GDP growth in the twelve months ahead. We track asset class behavior over time, both in terms of returns – gains and losses – and correlations to other asset classes. When historic data for asset classes is partitioned under broad macro-economic environments, patterns of behavior become obvious. The outlook falls into one of the following five broad descriptions: GROWTH, STAGNATION, RECESSION, INFLATION, or CHAOS, allowing for a transitioning in the period from one environment to another. Macro-economic environments contribute to asset class return distributions. As an economic cycle progresses through different economic environments, including Chaos and Recession, we know that asset classes experience a large distribution of returns, calculated over the measurement period.

Along with consideration of greater downside risk to asset classes from periodic extreme unexpected negative events, we incorporate this information to create tactical asset allocation portfolio models, delivered with an optimal combination of broad asset class exposure.

 

Expected Asset Class Behavior in Recession

Using a statistical sampling technique called bootstrapping, we can see that in a Recession Environment, U.S. Treasuries are expected to experience losses only 7.8% of the time and earn an average return of 11.62%.

 

Gold is expected to experience losses 37% of the time and earn an average return of 8.31%.

 

The S&P 500 is expected to experience losses 76% of the time and earn an average return of negative 9.2%.

 

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

We Positioned for Recession in February and Avoided Losses in the First Quarter in our Conservative and Moderate Growth Portfolio Models

We define the economic environment “Chaos” as a high impact, low probability event. In a Chaos environment, all asset classes become highly correlated and suffer simultaneous losses. In this environment, we look for asset classes that will be expected to experience low correlations as we move out of Chaos and typically into Recession. There is no question that the current pandemic event has had high impact. The low probability was considered low in the broader markets and economies up until February 19th, 2020, the peak of the S&P Dow Jones. But there were indications coming from China about the virility of the virus and the high mortality rate beginning in January. Without complete cessation of all movement of people across boarders at that time, we determined that it was inevitable that the virus would spread globally.

 

In our Portfolio Updates we highlighted the following:

January 20th, 2020:
“The trend towards populism and protectionist policy remains a risk to the stability of global financial markets while heightened geopolitical strains also have the potential to create volatility.”

“We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.”

February 19th, 2020:
“The coronavirus outbreak in China has generated economic waves that are disrupting global supply networks that act as the backbone of the global economy and comes as the global economy was already cooling off.”

“In February, we reduced exposure to U.S. equities across all models and reintroduced the U.S. long-term Treasury Bond. This reflects our view on deflationary influences that dominate the global economy.”

“The trend towards populism and protectionist policy remains a risk to the stability of global financial markets and the COVID-19 outbreak is likely to delay recovery and intensify disinflation.”

March 17th, 2020:
“A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.”

 

Because the market is forward looking, a Chaos environment is typically short lived and followed by a Recession. We are now positioned for Recession for the twelve- month period ahead.

 

 

Section 2. Four Themes

 

Theme 1: The Entire Global Economy is in Recession

The Great Lockdown is projected to shrink global growth dramatically. A partial recovery is projected for 2021, with above trend growth rates, but GDP will remain below the pre-virus trend, with considerable uncertainty about the strength of the rebound.

Global growth is projected at -3.0% in 2020, an outcome far worse than during the 2009 global financial crisis. The growth forecast is marked down by more than 6 percentage points relative to the October 2019 IMF and January 2020 IMF Update projections – an extraordinary revision over such a short period of time.vi

Recent economic reports helped fill in the picture of what happened to the economy in March and early April, and it is clear that the spread of COVID-19 led to a sharp contraction across much of the U.S. and other major economies. With the shutdown in China occurring in January, imports into the U.S. plunged in February, while exports had yet to be affected. With large parts of the U.S. domestic economy now closed, import demand will contract sharply over the coming months. Export demand so far appears to have held up much better, but widespread factory shutdowns means export volumes are likely to contract too.

The U.S. trade deficit will narrow in the next few months but should reverse over the rest of the year, as the stronger dollar weighs more on exports. With oil production dropping sharply, the U.S. is likely to return to being a net oil importer once gasoline demand recovers.vii

Canada will rack up debt faster in this crisis than any other developed country, relative to its economy, according to data from the IMF. It is fortunate that Canada’s governments went into this economic crisis in a much better financial position than most other developed countries. Net government debt (total government debt minus its cash holdings) was at 40% of economic output before the crisis. The average for developed countries was 107%. This may be why Canada’s governments have proven more willing to spend their way out of the crisis than some others.viii

 

Big-time fiscal deterioration in Canada

SOURCE: NATIONAL BANK FINANCIAL, IMF

NOTE: EUR = EURO AREA. COUNTRY AGGREGATES SHADED BLUE, CANADA RED.

 

Theme 2: Gold is a Safe Haven

Gold has played an important role in portfolios as a source of liquidity and collateral. Like most asset classes, gold is being affected by the unprecedented economic and financial market conditions in play around the globe. Recent volatility in the gold price has been driven by massive liquidations across all assets, and likely magnified by leveraged positions and rule-based trading.

Gold has also likely been used to raise cash to cover losses in other asset classes because it remains one of the best performing asset classes year-to-date, despite recent fluctuations, and it is a high quality and highly liquid asset. But coming out of the market selloff we have seen that the stronger the pullback in the stock market, the more negatively correlated gold becomes with the market, highlighting its effectiveness in a sustained pullback (see graph below).

Gold prices denominated in many other currencies, however, continued to reach all-time highs. This highlights a continued trend of growth in gold ETFs outside of the U.S. over the past few years; a trend underscored by European funds seeing the largest absolute inflows and Asia and other regions registering the largest percentage growth during the month. It serves as a safe haven in the longer term.ix

 

Correlation increased across all major asset classes except three-month Treasuries during the COVID-19 selloff

SOURCE: WORLD GOLD COUNCIL, BLOOMBERG

 

Theme 3: Oil Prices and Geopolitical Risk

Demand for oil has been hit by the coronavirus pandemic while global storage facilities are overflowing. International and domestic travel restrictions throughout the world and a sharp reduction in road traffic are expected to lead to a further decline in oil demand in 2020 that could exceed 10 million barrels a day, about 10 percent of global daily oil production.x

Confronting a weak demand environment, the OPEC+ coalition broke down on March 6th, 2020, leading to the worst one-day price drop in the oil market since 1991. This was repeated on April 21st. Oil prices had already declined 7.3% between August 2019 and February 2020, falling from $57.60 to $53.40, before further declining by 39.6% in March to $32.30 as the COVID-19 outbreak abruptly reversed a positive trend as containment measures directly hit the transportation sector, which accounts for more than 60% of oil demand.

After trading close to $20 toward the end of March, oil prices recovered somewhat in early April as the OPEC+ coalition resumed talks, but by mid-April the price of American crude oil crashed by more than a fifth, falling below $15 a barrel to its lowest point in two decades. The slump came even as OPEC producers and their allies have promised to slash production.xi

The drop in oil prices has already had a marked impact on Canada’s dollar. Canada’s currency is likely to remain around 70 US cents in the near term as uncertainty about the depth and duration of the crisis sees investors gravitate to the safety of US dollars.

 

Theme 4: Global Currency Revaluation

Every recession, financial crisis or geopolitical shock has left a permanent imprint on at least one major asset class. COVID-19’s aftermath is expected to involve at least one regime change. (See Frame Global Asset Management White Paper 3).

The currencies of commodity exporters with flexible exchange rates among emerging market and advanced economies have depreciated sharply since the beginning of the year, while the US dollar has appreciated by some 8.5% in real effective terms as of April 3rd, the yen by about 5%, and the euro by some 3%.xii The broad dollar will continue to be supported by the ongoing deleveraging demand and will maintain a bid against Emerging Market currencies where there are balance sheet vulnerabilities, and Petro currencies which will continue to suffer from the oil supply glut.

While the COVID-19 shock is depressing both global demand and supply, a demand shock this large will probably produce the first negative year-on-year readings on global CPI inflation in several decades. This decline is not just an energy price effect: global core inflation could drop below 1% for the first time in at least 20 years, which will sustain central bank concerns of deflation even once the expansion materializes.

Longer term implications, given the scale of the Fed’s purchases of Treasury securities in the first few weeks of the pandemic and the size of the broader expansion in its balance sheet, suggest that the Fed is monetizing the deficit. The monetary base expansion will eventually trigger a corresponding rise in broad money and consequently, when the economy’s resources are fully utilized again, the prices of goods and services too.

The revenue loss around a recession results with the contraction in aggregate demand. Margin compression is by far the biggest contributor to profit losses in a recession. Margins are driven by many factors, but the three most important are: prices (a positive), wages (a negative), and productivity (a positive). Roughly two-thirds of the variation in global corporate profit growth can be explained by the difference between price inflation and growth in unit labor costs (that is, wages relative to productivity). During recessions, wage inflation is held back but this pales in comparison to the loss in pricing power. At the same time, some degree of labor hoarding creates pro-cyclicality in productivity growth.

Inflation and margin compression will factor into the revaluation of global currencies. We will continue to monitor these.

 

 

Section 3. Investment Outlook

 

Global Pandemic Leads Us to a Recession Forecast for the Next Twelve Months

 

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

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.

 

 

Section 4. March 2020 Portfolio Models

A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.

In March, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

April 14, 2020

 

iIMF. World Economic Outlook. April 14th, 2020.
iiIMF. World Economic Outlook. April 14th, 2020.
iiiIMF. World Economic Outlook. April 14th, 2020.
ivCapital Economics. U.S. Economic Update. April 16th, 2020.
vCapital Economics. U.S. Economic Update. April 16th, 2020.
viIMF. World Economic Outlook. April 14th, 2020.
viiCapital Economics. U.S. Economic Update. April 16th, 2020.
viiiNational Bank of Canada. Public Sector Debt. April 15th, 2020.
ixWorld Gold Council. April 8th, 2020.
xCapital Economics. U.S. Economic Update. April 16th, 2020.
xiCapital Economics. U.S. Economic Update. April 16th, 2020.
xiiTrading Economics. Currencies. April 20th, 2020.

 

A global recession in 2020 is all but confirmed as nations shut down economic activity to limit the spread of COVID-19. The virus is unique in that it is a demand shock and supply shock, and also a negative wealth, oil price, and credit shock. There will be a wide range of subsequent effects. We are monitoring these developments and have updated our previous Stagnation followed by Recession outlook for the U.S. economy to reflect a Recession in March, extending through to the end of the year, as the situation will deteriorate further before beginning to recover.

There is evidence that the disease has likely peaked in China. The Bloomberg China Economic Recovery Index shows that 70% of economic activity was restored by March 9th, up from just 27% at the beginning of February.1 A coordinated global response has started to emerge. Based on the experience in China, virus incidents are unlikely to peak in Europe and the U.S. until June.

The Russia-Saudi spat that has resulted in the current global oil glut and the expected decline in demand due to this pandemic will keep oil prices low with mixed effect across economies. It will have a negative impact on oil-exporting emerging markets outside Asia, while also affecting oil-and-gas related capital expenditure in the U.S. Net oil importers in Europe and Asia will be beneficiaries although the stronger US dollar will offset a portion of the benefit.

In January, a record 31.8 million Americans were employed in retail trade, hotels and motels, air transportation, restaurants and other eating places, arts, entertainment and recreation, and offices of real estate agents & brokers.2 Many of these establishments have seen their businesses collapse in recent weeks and have reduced their payrolls significantly. As we enter the third week in March, 158 million Americans have been told to stay home from work and other activities.3 This doesn’t include the multiplier effects on other industries. Initial unemployment claims and the unemployment rate are soaring and will remain high through the second quarter.

Market behavior in recent weeks has broken records for the speed of its decline. It took only 16 trading sessions for the S&P 500 to fall 20% from its highs, the quickest descent into bear market territory on record.4 U.S. equities were battered in February, down 13% from their peak on February 19th. The S&P 500 was down 8.2%, while smaller caps lagged, with the S&P Midcap 400 and the S&P SmallCap 600 down 9.5% and 9.6%, respectively. The S&P/TSX Composite was down 5.9%.

Asian equities took part in the sell-off, with the S&P Pan Asia BMI closing the month with a decline of 6.6%. European equities struggled in the face of a broader global sell-off. The S&P Europe 350 dropped 8.6% on the month. U.K. equities continued to lag their European counterparts; the S&P United Kingdom declined 9.0% on the month, returning all of its gains from the past 12 months.

In March, we maintained the asset allocation positioning that we established on February 19th. This reflects our view on deflationary and recessionary influences that dominate the global economy.  Allocation to equities was reduced in February to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. In February, within the Fixed Income allocation, we added the 20+ year Treasury Bond. As of March 25th, the 10- year treasury yield has declined by 1.577% since the start of the year, rewarding this position. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

Historically, central bank stimulus is bullish for bullion. In the early days of the selloff, safe haven assets such as gold and treasuries sold off when margin calls on equities and credit occurred as equity portfolio managers were sitting with record-low cash buffers. Gold provides diversification in a portfolio and is correlated with the stock market, becoming inversely correlated during periods of stress. In a world of historically low interest rates, gold is a safe-haven. Similar short-term movement was seen in the ten-year note and in State and Local government bonds and Mortgaged Back Securities guaranteed by the federal government in response to liquidity funding requirements.

The shape of the recovery from the pandemic and for the global economy are highly correlated.  The second-order effects of schools closing, businesses closing due to staff absence, and a paralysis in consumer and corporate confidence will create challenges for commerce and credit markets. Policymakers will need to protect both supply and demand by providing ample liquidity to banks and corporations, in order to minimize the risk of default and job losses. The trend towards global populism and protectionism remains a risk to the recovery. We expect to see prolonged disinflation. We will continue to monitor the data for growth, inflation, and recession 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

 

1Bloomberg. China Economic Recovery Index. March 9, 2020.

2Trading Economics, United States Employed Persons. January 2020.

3New York Times, World Coronavirus Updates. March 23, 2020.

4Financial Times. “S&P 500 suffers its quickest fall into bear market on record”. March 13, 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. February 28, 2020. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The coronavirus outbreak in China has generated economic waves that are disrupting global supply networks that act as the backbone of the global economy and comes as the global economy was already cooling off. Profit warnings from companies with significant operations in China and abroad have begun. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy will shift to Recession beginning in the back half of the twelve-month time horizon.

China is likely heading into a consumer recession, as auto sales there plunged 18% year over year in January to their lowest level in eight years.1 China accounts for 16% of global GDP on a US dollar basis, compared to 4% in 2003.2 In 2019, China accounted for 75% of total world oil demand.3 Commodities markets have tumbled as factories are idled. Iron ore demand is down more than 10% this year. Copper and nickel are down about 8%, while zinc and aluminum are both down more than 5% in 2020.4

In Japan, the world’s third-largest economy declined 1.6% in the fourth quarter of 2019 as the country absorbed the effects of a sales tax hike and a powerful typhoon. It was Japan’s largest contraction compared to the previous quarter since 2014.5

The U.K. and Germany managed to escape a technical recession while France and Italy contracted. Switzerland’s core CPI declined 0.5% sequentially in January. Italy, Germany, and France experienced a 2.7% decline in December industrial production. EU auto sales also declined 7.4% YoY in January.6 The UK’s future trade relationship with the EU remains unanswered. Brexit has already cost the UK economy between 2.5-3.0% of lost output.7 The final economic bill will depend on the extent to which EU trade is disrupted as the UK pursues greater autonomy over regulation, migration, and state aid.

In the U.S. the budget deficit to GDP ratio stands at 4.9%, up from 4.3% a year ago. The last time we saw this level was in May 2013 when the unemployment rate was 400 basis points higher than it is today at 7.5%.8 January nonfarm employment growth was 225,000 jobs. While the unemployment rate ticked up to 3.6%, this increase was driven by a jump in labor force participation.9 The coronavirus impact will be felt in the U.S., resulting in weaker exports, imports, and inventories. Canada’s economy has stalled as transportation activity has been disrupted by blockades set up by anti-pipeline protestors. Real manufacturing shipments fell 0.4% in December and real retail sales were flat. A recent rise in insolvencies comes amid a relatively robust job market.10

U.S. equities started the year strongly, but gains were erased towards the end of the month as a result of coronavirus fears. The S&P 500 was flat in January while the S&P MidCap 400 and the S&P SmallCap 600 were down 2.6% and 4.0%, respectively. Canadian equities were positive, with the S&P/TSX Composite up 1.7%. The S&P Europe 350 finished January with a loss of 1.3%, ending a four-month streak of gains. The S&P United Kingdom lagged its European counterparts in January, with the index declining 3.3% in pound sterling terms. U.S. fixed income performance was positive across the board, with treasuries and corporates leading the way. The decline in the U.S. long bond’s yield reflects a confluence of factors including easy Federal Reserve monetary policy, concerns about the COVID-19 epidemic’s impact on economic growth, and an absence of inflationary pressures. Gold is continuing its advance, after breaking out from a six-year base formation, rising as the US dollar rises, not the usual correlation.

In February, we reduced exposure to U.S. equities across all models and reintroduced the U.S. long-term Treasury Bond. This reflects our view on deflationary influences that dominate the global economy. Allocation to equities was reduced to 12% in Tactical Conservative, 17% in Tactical Moderate Growth, 26% in Tactical Growth, and 34% in Tactical Aggressive Growth. Within the Fixed Income allocation, we added the 20+ year Treasury Bond as long rates are expected to decline further. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The trend towards populism and protectionist policy remains a risk to the stability of global financial markets and the COVID-19 outbreak is likely to delay recovery and intensify disinflation. We will continue to monitor the data for growth, inflation, and recession 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

 

Trading Economics, China Vehicle Sales. February 13, 2020.

Visual Capitalist. 70 Years of China Economic Growth. October 12, 2019.

Trading Economics, China Imports of Fuel Oil. February 2020.

Trading Economics, Commodity Prices. February 2020.

Trading Economics, Japan Q4 2019 GDP. February 2020.

Trading Economics, E.U. Economic Data. February 2020.

Oxford Economics. Brexit. February 2020.

Trading Economics, U.S. Debt to GDP. February 2020.

Trading Economics, U.S. Non-Farm Payrolls. February 2020.

10 Trading Economics, Canada Insolvencies. February 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. January 31, 2020. Index performance is based on total returns and expressed in the local currency of the index.

Global growth is projected to reach 2.5% in 20201. Reduced trade uncertainty combined with last year’s easing in financial conditions helped business sentiment stabilize in many major economies. The U.S. dollar benefitted from safe-haven demand over the past year amid this trade uncertainty. Global manufacturing activity generally remains soft; the global manufacturing PMI fell to 50.1 in December, consistent with stagnation.2 Trade challenges between the world’s two largest economies are likely to continue, with no long-term deal to tackle structural issues and imbalances between the U.S. and China. Growth forecasts for advanced and developing economies have been revised down as a result of weaker than expected trade and manufacturing activity. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

GDP growth in China has slowed to 6% in the third quarter of 2019, its slowest pace in about 30 years.3 Policymakers are focused on measures to limit risks arising from excessive debt burdens, even if it means weaker rates of growth. An uptick in infrastructure projects towards the end of last year has been the main driver of growth. Eurozone growth continues to underperform, dampened by the gradual slowdown in China, the ongoing Brexit saga, White House protectionism, and the threat of more tariffs. The accommodative policy measures implemented by the ECB and fiscal policy should continue to prop up the economy. Concern grows about the corrosive side effects of negative interest rates as the ECB’s bond-buying program nears its self-imposed limits.

The U.S. leads the global charge as their economy is entering its eleventh year of expansion, the longest on record. The consumer remains the main source of strength due to strong job gains and low interest rates that have bolstered spending. While the U.S. has proven successful in securing a trade deal with Canada and Mexico and extracting a “phase one” trade agreement with China, vulnerabilities remain due to their sizeable trade deficit. As a share of GDP, the U.S.’s goods trade deficit over the last two years has narrowed only marginally below the last decade average, driven mainly by a slight reduction in U.S. import demand, where lower merchandise imports from China have been replaced by imports from Mexico, Europe, and developing countries in Asia.4 The PMI for the sector hit its lowest level in a decade in December.5 Conflicts in Iraq and Afghanistan have left the American public strongly opposed to further major conflicts in the Middle East and a direct conflict with Iran would raise downside risks to business activity. For Canada, healthy demand stateside and receding North American (USMCA) trade tensions helped facilitate the much-needed rotation towards exports and business investment from the consumer and housing sector in the fourth quarter.

One of the most notable effects of last year’s Fed rate cuts was support for asset prices. U.S. equities ended 2019 strongly with the S&P 500 up 31.5% for the year, despite lackluster profits, slowing global growth, and recession fears. It is worth noting that a late-2018 selloff provided a flattering comparison for 2019. Mega-caps dominated as gains for the S&P MidCap 400 and the S&P SmallCap 600 were 26.2% and 22.8% for the year, and 2.8% and 3.0% for December, respectively, while the S&P 500 was up 3.0% for the month. U.S. fixed income performance was positive across the board. The S&P/TSX Composite gained 22.9% during 2019 and was up 0.5% in December, closing out the decade with its best annual performance since 2009. European equities also experienced their best year since 2009 with S&P Europe 350 up 27.2% for the year and 2.1% for December. The S&P United Kingdom finished 2019 up 17.2% for the year. Commodities also rallied, with the DJCI up 10.1% and the S&P GSCI up 17.6% for the year, driven by gains in Energy and Precious Metals.

In January we maintained the December allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Within the Fixed Income allocation, we maintained the weight of the 7-10-year maturity in order to protect the portfolio from a rebound in long rates. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

The trend towards populism and protectionist policy remains a risk to the stability of global financial markets while heightened geopolitical strains also have the potential to create volatility. We will continue to monitor the data for growth, inflation, and recession 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

 

The World Bank Group. Flagship Report. Global Economic Prospects. January 2020.

2 J.P. Morgan Global Manufacturing PMI. News Release. January 2, 2020

Trading Economics. China GDP. January 20, 2020.

Trading Economics. U.S. Goods Trade Deficit. November 26, 2019.

Trading Economics. U.S. PMI. January 2020.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. December 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

Section 1: Q1 2020 Outlook

 

Current Risks of a Reserve Currency Trap

The U.S. economy represents 33% of the global economy, but its spill-over effects on the rest of the world are amplified by the dominant role of the US dollar (USD) in international payments, debt issuance, and FX reserves.i

The trust and confidence that the world has in the ability of the United States to pay its debts have anointed the dollar as the most redeemable currency, facilitating world commerce. This has led to the rapid accumulation of foreign exchange (FX) reserves throughout the global economy over the last 25 years.

As global asset allocators, our ETF Portfolio Models are exposed to foreign currency risk -primarily US dollars. Relative currency movement can be significant and have a positive or negative impact on investment returns. As with our approach to all asset classes, we want to participate on the upside and protect on the downside.

In the case of currency exposure, while we may be allocating specifically for downside protection in a non-Canadian asset class, i.e., the U.S., it may be the case that a weaker US dollar could diminish the benefit of the U.S. exposure. In these events, we apply a neutral hedge to the entire portfolio.

In this Q1 2020 Outlook, we take a look at the risks that exist of an unexpected shift in global central bank US dollar reserve balances.

The US dollar reserve status is based largely on the size and strength of the U.S. economy and the dominance of U.S. financial markets. Despite large deficit spending, trillions of dollars in foreign debt, and the printing of US dollars and US Treasury securities remain the safest store of money.

The dominance of the US dollar, reflected in its role as a global anchor for prices and interest rates, can force central banks to hold excessive USD-denominated foreign exchange reserves to match the significant USD exposure from trade and borrowing of the respective economy. The dominant role of the USD in credit and investment markets impacts investment flows to emerging economies by increasing volatility. Investment flows to emerging markets can reverse much faster than they have built up over time, making them act like very destructive pro-cyclical amplifiers in crisis situations. The role that oil prices play in the level of the USD is significant but may now be overshadowed by the sheer volume of dollar reserves that are now on the balance sheets of central banks around the globe.

 

A New Relationship Between Oil and the US Dollar

Considering the new dynamics of the global energy market, the United States has become the world’s marginal producer of oil products, and the US dollar has been seen to trade more like a petrodollar since 2015.

A barrel of oil is priced in US dollars across the world, so by definition, strength in the US dollar means it takes fewer greenbacks to buy a barrel of oil (all else equal) and weakness in the US dollar makes the price of oil appear higher in dollar terms. Each uptick and downtick in the dollar or in the price of the commodity generates an immediate realignment between the US dollar and numerous forex crosses. These movements are less correlated in nations without significant crude oil reserves, like Japan, and more correlated in nations that have significant reserves like Canada, Russia, and Brazil.

Many nations leveraged their crude oil reserves during the energy market’s historic rise between the mid-1990s and mid-2000s, borrowing heavily to build infrastructure, expand military operations, and initiate social programs. Those bills came due after the 2008 economic collapse, where some countries deleveraged while others doubled down, borrowing more heavily against reserves to restore trust and trajectory to their wounded economies.

These heavier debt loads helped keep growth rates high until global crude oil prices collapsed in 2014, dumping commodity-sensitive nations into recessionary environments. Canada, Russia, Brazil, and other energy-rich countries have struggled since then.

Because the United States has historically been a net importer of oil products, rising oil prices meant that the United States’ current account deficit would rise as citizens and companies shipped more currency abroad. Due primarily to the success of horizontal drilling and fracking techniques, the U.S. shale revolution has dramatically increased domestic petroleum production. The United States became a net exporter of refined petroleum products in 2011 and has now become the third-largest producer of crude oil after Saudi Arabia and Russia.iii According to the Energy Information Administration, the United States is currently about 90% self-sufficient in terms of total energy consumption.iv Economically, this means that higher oil prices no longer lead to a higher U.S. deficit, and in fact, can decrease the deficit in certain situations.

 

Canada is an Important Net Exporter of Oil

When it comes to the US/Canadian dollar relationship, the USD/CAD exchange rate is determined by the demand and supply of Canadian and US dollars. The CAD has a high correlation to U.S. oil because of the large portion of CAD oil exports that are shipped to the United States.

Canada has the third largest volume of oil reserves in the world after Saudi Arabia and Venezuela. Canada’s economy is dependent on exports and is the fourth largest exporter of crude oil in the world.v Approximately 96% of its exports go to the U.S., including over 3 million barrels of oil and petroleum products per day.vi Canada and OPEC Countries represent the major sources of U.S. petroleum imports at 38% and 34% respectively. Because of the volume involved, it creates a huge amount of demand for Canadian dollars.

Due to the country’s status as a net exporter of oil, its currency in relation to the USD is highly correlated to oil prices, meaning that they move in similar directions to each other. Other factors can influence the USD/CAD exchange rate including the relative inflation rate, interest rates, balance trade, public debt, OPEC decisions, political stability, and economic performance.

 

 

The 2008 financial crisis, the 2015 oil slump, and correlation breaking down in 2018 are all notable events on the timeline. Despite the history of correlation between CAD and crude, the relationship appears to have broken down late 2018 when oil’s surge made the Canadian dollar decline. This divergence is due to factors such as OPEC policies being a key influencer of oil price rather than supply and demand factors, monetary policy, and Canada’s efforts to diversify its economy and lessen its reliance on oil.

 

A New Dominant Factor Driving Foreign Exchange Rates and the US Dollar: The Failed Clean-Up of the Financial Crisis

A benefit of crises and recessions is that they remove both unproductive firms and financial excess, creating space for more productive firms and fresh financial investment. This was not allowed to happen after the Recession of 2008 and is why the economic recovery from the crisis was so weak. More than ten years later, through FX reserves and through QE programs, central banks globally hold government bonds issued by a relatively small number of advanced economies.

The global financial crisis (GFC) was a massive failure of risk-hedging in the financial sector, combined with both regulatory failures and dangerous and deeply embedded incentives. While the extraordinary measures used to stop the crisis from mutating into a systemic meltdown can be considered appropriate, extending these measures through the past decade cannot.

The U.S. recapitalized, merged, and permitted the failure of some banks, but Europe chose the opposite approach resulting in undercapitalized and ailing banks surviving. However, the most impactful mistakes were made after the GFC on both sides of the Atlantic. Many central banks enacted zero or negative interest rate policies and started asset purchase Quantitative Easing (QE) programs run through the commercial banks. In the U.S., the Fed purchased securities from authorized Primary Dealer banks by crediting reserve balances to the Fed accounts associated with each dealer counterparty. These intermediary banks paid the sellers of bonds (households, funds, banks, etc.) and the Fed compensated the banks with reserves. In practice, the Fed forced excess reserves onto the balance sheets of banks far beyond levels they would have acquired independently. Because of the higher supply of reserves system-wide, their marginal benefit decreased, bidding-up the prices of various securities. This led the banks to issue additional and often riskier loans until the balance of the marginal benefits was restored. Also, because QE and low policy rates depressed long-term rates, many of the securities that the commercial banks held had no yield advantage over reserves, making the banks more likely to substitute less-liquid securities with more credit risk.

Using QE, central banks can buy various fixed income assets including government bonds, corporate bonds, asset-backed securities, and in a few cases, equities (in the case of Japan, for example). However, the bulk of QE programs concern government bonds with the goal of curbing long-term interest rates across economies. Of the USD 11 trillion of QE programs, it is estimated that USD 9 trillion originate from central banks’ acquisitions of government bonds from the countries concerned.vii

Despite increased diversification, the bulk of FX reserves are still held in government bonds issued in a select number of advanced economies including the U.S., Europe, and Japan. Approximately 70% of global reserves (ex-gold) are invested into the government bonds issued by these economies. This means that either through FX reserves or through QE programs, central banks hold around USD 18 trillion of government bonds issued by a relatively small number of advanced economies.viii The total stock of government debt issued by these countries was around USD 40 trillion at the end of 2018.ix This means that central banks currently hold nearly half of global ‘safe assets’, i.e., government bonds issued by leading advanced economies such as the U.S., Japan, European states, and a few others.

Falling current account surpluses point to lower growth in FX reserves. But given the safe haven status of Japan and Switzerland in times of geopolitical uncertainty, they may need further interventions to prevent their currencies from appreciating too much.

The growth in FX reserves managed by Emerging Markets grew with the growth of emerging market economies and the commodity price boom. It continued uninterrupted after the financial crisis of 2008 as growth in Emerging Markets remained resilient, despite the recession in advanced economies. Oil prices were quick to recover from the temporary drop experienced during the most acute phase of the global crisis, thus filling the coffers of commodity-exporting economies.

The massive holdings of government bonds by central banks through FX reserve and QE raises two important questions.

At a policy level, is there a potential conflict of interest between monetary policy and asset management objectives?

Should central banks become concerned about potential losses on their holdings, given their focus on capital protection, will they be tempted to adopt a pro-cyclical behavior. Ultimately, this is an issue of international coordination among central banks as reserves held by emerging markets are often invested into bonds acquired by advanced economies’ central banks via QE programs. This international coordination may dominate over underlying demand and supply drivers including global oil demand.

The second question relates to investment risk. Can central banks weather the inevitable drop in prices that will accompany a future rise in interest rates?

As a result of the decline in global interest rates to zero or even negative levels, government bonds are a very expensive asset in both absolute and relative terms. Central banks are exposed to potentially large losses should interest rates rise. While it is true that central banks often hold bonds until maturity accounted for on an accrual basis, since most of these institutions adopt a mark¬ to-market approach in the measurement of their investment portfolio, any drop in prices on such holdings is reflected in their reported profits and losses. For central banks doing QE, the risk is further increased by significant holdings of these additional fixed income assets.

The dominance of the USD reflects several factors such as the size and depth of its financial markets, and the U.S. dominance in global affairs. From an investment perspective, the USD is the ultimate safe-haven currency and during periods of heightened global risk, investors flock to the U.S. Treasury market. This has not changed over the last 25 years and it is still true today as shown by the rise of the USD when uncertainty in global markets rises.

Central banks may engineer economic growth and generate moderate but manageable inflation, but the stresses that have accumulated on central bank balance sheets may be felt as reversing interest rates eventually happen. We will be carefully monitoring this.

 

 

Section 2: 4 Themes

 

Theme 1: Gold is a Safe Haven

Gold has long been recognized as a safe haven, an asset that investors seek out for protection and security during uncertain times. In early 2020, tensions in the Middle East, driven by the U.S.-Iran confrontation, supported safe-haven flows, pushing the gold price to a six-year high.

Other reasons for the strength in gold prices include:

• A technical breakout
• Bullish positioning in derivatives markets
• Light trading volumes
• Portfolio rebalancing at the end of 2019 especially as investors hedged risk asset allocations
• Federal Reserve repo activity
• Rebalancing ahead of 2020

According to the World Gold Council, of the current average global annual demand of about 4350 tonnes, about 10% of that comes from central banks. With purchases of over 600 tonnes in 2018, central banks bought more than their long-term average in that year. This trend has continued in 2019 and early 2020.x As we have highlighted in this report, gold’s behavior is highly correlated with the US dollar. And today, the lack of credit risk makes gold an attractive reserve monetary asset among central banks.

Over the last few decades, investors have shunned gold because it doesn’t produce any income, and therefore the opportunity cost of holding it was significant. In the current era of low and negative interest rates, that opportunity cost is less of a factor, thus highlighting gold’s diversification benefits.

While bonds and cash may also increase portfolio efficiency, gold is an attractive alternative because it is less impacted by interest rates. Rising interest rates put downward pressure on bond valuations, which can make holding them less attractive to investors. Additionally, negative interest rates may push cash yields to negative, on a real basis. Gold also has a low correlation to equities and a historically low correlation to bonds. Moreover, this low correlation to major asset classes holds in both times of expansion and recession. During times of expansion, goods and products that rely on gold, such as jewelry and technology, are often in high demand. In times of recession, there is a gold surge among people seeking a financial safe haven. The benefits of low correlation to stocks and bonds aren’t limited to any one type of investor or one particular risk profile.

The most recent annual statistics from the World Gold Council indicate that the main buyers of gold in 2018 were the central banks of Russia (274 tonnes), Turkey (51 tonnes), Kazakhstan (51 tonnes), India (42 tonnes) and Hungary (28 tonnes). China, which only bought 10 tonnes in 2018, increased its gold purchases in 2019.xi

The Fed began reducing their balance sheet in 2018 but reversed this decision in the second half of 2019. They began regular repurchase market injections totaling nearly US$500 billion in the fourth quarter of 2019.xii This activity has continued into 2020 and has been described by some market participants simply as another form of QE – often dubbed “QE light” – causing some investors to worry about liquidity in the Treasury market as a whole. Historically, expansions of QE have led to increases in the gold price.

As highlighted in this report, for several countries, diversification away from US dollar assets has a strategic component. Not only does gold not have a default risk, it is not a title that has to be enforced via Western-based courts nor is it dependent on the U.S.-led financial system.

 

The Fed began to increase their balance sheet in Q4 2019

SOURCE: BLOOMBERG, WORLD GOLD COUNCIL

 

Theme 2: Oil Prices and Geopolitical Risk

Early in January 2020, in a “flight-to-safety” move following the bombings of U.S. bases in Iraq, gold and oil both rallied sharply but following the announcement that Iran was “standing down,” oil dipped while gold was up. And while gold is one of the strongest performing asset classes this year, oil is one of the weakest.xiii

From the perspective of the oil market, there has been a major structural change to the market that may offer an explanation. In the past, oil prices were the main transmission mechanism from major Gulf conflicts to the broader global economy and financial markets. However, the U.S. is now a net exporter of petroleum products, which was not the case during either the first or second Gulf War. The U.S. has essentially achieved energy independence and it can now use its own supplies to offset the impact of Middle Eastern supply shocks. It appears that oil market participants would need to see sustained physical market disruption to justify adding significant risk premia to energy prices.

 

U.S. Net Imports of Crude Oil and Petroleum Products

SOURCE: U.S. ENERGY INFORMATION ADMINISTRATION

 

The law of unintended consequences is hard at work when one considers any type of escalation in the conflict between the U.S. and Iran. And while the Strait of Hormuz has not been blocked, the option cannot be completely ruled out. It is important to think through the potential effects that a blockade could have not only on pricing or availability of crude but also on the geopolitical power transfer to a player like Russia, who is already seen as a strategic and diplomatic beneficiary of the U.S.-Iran conflict as well as the forced departure of U.S. forces from Iraq.

One of the reasons why OPEC has had such a great influence on the world’s crude market is its ability to increase (or decrease) production at any given time to dampen potential swings in oil prices. This ability hinges mostly on OPEC’s most powerful member (not only in terms of crude supply or spare capacity): Saudi Arabia, which disposes of OPEC’s bulk, and the world’s largest, crude spare capacity, approximately 1.5-2 million barrels per day.xiv With a blockade or severe limitation in traffic in the Strait of Hormuz, Saudi Arabia’s ability to release its spare capacity to the market would be greatly impeded.

U.S. shale producers who in the beginning benefit from high crude prices cannot be helpful in the same way Saudi Arabia can. Shale production can respond quickly to changing market conditions—much quicker than conventional crude production—but not as quick as a guarantee of an immediate release of additional volumes.

Important to consider also is that since U.S. crude production is in the hands of private companies, it is dictated by the market. It cannot be stopped at a certain price level but will flow until the market saturates. Also, U.S. crude quality differs substantially from Saudi crude. U.S. shale is lower in density (lighter) and sweeter (includes less sulfur) and, as such, cannot immediately act as a substitute.

One country that can benefit is Russia. Russia produces the “right” quality of crude (a substitute for the crude potentially locked in by the Strait of Hormuz), and according to a Russian government statement, it holds spare capacity of 500,000 barrels per day.xv The country cut its oil production due to an agreement with OPEC to prevent oil prices from falling too low in a high-supply environment. With oil prices rising and OPEC generally unable to provide relief, Russia and its oil companies (generally not happy with the production cuts) would surely jump at the opportunity to make the extra buck. Higher prices and production would also benefit Russian companies, as crude is traded in US dollars and the country needs currency reserves after the U.S.-imposed sanctions on Russian financial institutions following Russia’s invasion of Ukraine and interference in U.S. elections.

Russia also stands to gain geopolitical influence. Russia’s leverage in the global oil market has increased in the recent years. The country has become an important partner to OPEC in its struggle to remain the deciding entity to influence oil prices after the U.S. shale revolution unfolded. A blockade of the Strait of Hormuz could potentially strengthen Russia’s position in Asia since about three-fourths of the crude that passes through the Strait lands there.xvi This is added to the increasing importance of Russian natural gas that flows to the Chinese market via the newly opened Power of Siberia pipeline. If OPEC’s crude exports were significantly impaired by Iran-U.S. conflict, Russia would stand to profit handsomely in terms of both actual revenues and in terms of geopolitical influence, as recent military exercises among Russia, China, and Iran in the Gulf of Oman remind us.

 

Theme 3: Ultra-Low Rates

Central banks around the world cut interest rates in 2019 to stoke economic growth. Population aging and weaker productivity are set to constrain growth, softening demand for credit. Technology, low inflation, and demographics have fed the demand for fixed income securities and driven interest rates down around the world. Ultra-low interest rates have enhanced household wealth by boosting prices for housing and equities while at the same time hurting savers and pensioners.

Adding in globalization and a slowdown in Europe, an inability to get the economy moving in Japan and the need of the central bank to react have all continued to feed the move to zero and negative rates.

The era of extraordinarily low interest rates has forced central banks to become more creative in responding to periods of economic weakness. They are now in a trap that forces these banks to rely on unconventional monetary policies, including forward guidance, quantitative easing, funding for credit, and negative interest rates, which all may turn out to be less effective than traditional rate cuts.

The amount of global debt trading at negative yields hit a record US$17 trillion in August 2019, as more investors were willing to accept a negative rate in exchange for a safe place to park their money.xvii

In Canada, we have not seen sub-zero rates on Canadian dollar issuance. But US$85 billion of mostly euro-denominated Canadian debt (provincial, corporate, and covered bonds) is trading at negative yields.xviii Outside of Canada, positive real yields after inflation exist in long-term interest rates in Portugal, Spain, Italy, and the 30-year treasury in the U.S. The 10-year treasury, at the headline level, remains negative.

Negative interest rates are toxic for the financial system. For now, the global financial system has an out in that the reserve currency of the world, the US Dollar, has the highest positive rates, providing a buffer for now.

 

Theme 4: Slowing Global Growth, Tariffs, and Trade

Global GDP is on track to rise 3%, the slowest pace in a decade, reflecting sagging business confidence that undermined investment and trade. Global trade volumes fell in 2019 for the first time since the Great Recession, reflecting rollercoaster U.S.-China trade negotiations, a lack of progress on Brexit, and political unrest in Hong Kong and some Latin American countries. Manufacturers were hardest hit, with the global measure of activity contracting for six straight months. Business investment in OECD countries edged up 1% in the first half of 2019, a marked slowing from a 3%-plus average pace in 2017-18. Amid these difficulties, the services sector held up. As we have highlighted in this report, central bankers have responded by injecting stimulus to keep the decade-long expansion going.

In the U.S., easier financial conditions did little to help manufacturers in 2019. The factory sector entered its worst slump since 2015-16 and the ISM manufacturing index declined steadily throughout the year, hitting a cycle low in December. Temporary shutdowns in the auto sector and aerospace have added to the sector’s woes, but the bigger issue last year was escalating trade tensions. A recent Fed paper analyzing U.S. import tariffs found that, in more tariff-exposed manufacturing industries, the negative effects of higher input costs and other countries’ retaliatory measures more than offset any positives from import protection. Added to this is the negative impact of trade policy uncertainty on business investment, which had knock-on effects for manufacturers via slower orders for capital goods.

The nation’s economy is becoming increasingly concentrated in large cities and by the coasts, and less so in rural counties. This leads to the question of whether rural areas will be increasingly left behind. The growing concentration of the country’s economic activity could impact a variety of things from infrastructure spending to labor mobility, but it’s unclear how rural areas will fare as their share of economic output continues to dwindle.

The anticipated USMCA ratification and a preliminary U.S.-China trade deal should resolve some of the trade concerns. On New Year’s Eve President Trump tweeted that he would sign a Phase One trade deal with China on January 15th at the White House, and that he would travel to Beijing at an unspecified later date to begin discussions on a Phase Two agreement. Phase One includes a partial rollback of tariffs imposed in September on $120 billion of Chinese goods and cancellation of those planned to implementation on December 15, 2019, mainly in exchange for higher Chinese purchases of U.S. agricultural commodities over the next two years.xix This truce should allow China’s export sector to gain momentum in 2020 although uncertainty about the path ahead will remain high.

Unfortunately, substantial tariffs remain in place and the Trump administration’s unpredictable approach to trade policy will continue to cause some firms to postpone investment plans. Uncertainty leading up to the November 2020 election could also delay some capital spending.

 

 

Section 3. Investment Outlook

 

Slowing Global Growth and Inverted Yield Curves Leads Us to a Stagnation Forecast for the Next Twelve Months

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

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.

 

 

Section 4. December 2019 Portfolio Models

We have maintained our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months.

As uncertainty revs up, global GDP is on track to rise 3% in 2019, the slowest pace in a decade. Global trade volumes fell in 2019 for the first time since the Great Recession, reflecting rollercoaster U.S.-China trade negotiations, a lack of progress on Brexit, and political unrest in Hong Kong and some Latin American countries. Central bankers have responded with stimulus to keep the decade-long expansion going. While low interest rates and accommodative financial conditions will likely prolong the expansion, much will depend on geopolitical influences. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

We will continue to monitor the data for growth, inflation, and recession 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, CFA, MBA

President and Chief Investment Officer

January 14, 2020

 

iTrading Economics. U.S. GDP. January 2020.
iiiU.S. Energy Information Administration. What Countries are the top producers and consumers of oil? January 2020.
ivU.S. Energy Information Administration. January 2020.
vNatural Resources Canada. Crude Oil Facts. January 2020.
viNatural Resources Canada. Crude Oil Facts. January 2020.
viiCastelli, Massimiliano; Salman, Philipp. (2019) Time to evolve. UBS Asset Management.
viiiCastelli, Massimiliano; Salman, Philipp. (2019) Time to evolve. UBS Asset Management.
ixCastelli, Massimiliano; Salman, Philipp. (2019) Time to evolve. UBS Asset Management.
xWorld Gold Council. Outlook 2020. Global economic trends and their impact on gold. January 2020.
xiWorld Gold Council. Outlook 2020. Global economic trends and their impact on gold. January 2020.
xiiTrading Economics. U.S. Fed Funds Rate. January 2020.
xiiiPerlaky, Adam. Recent gold and oil movements highlight inconsistent long-term correlation. World Gold Council. Goldhub blog. January 14, 2020.
xivMikulska, Anna. How Russian Oil Has The Most To Gain From Iran-U.S. Crisis. Baker Institute. January 8, 2020.
xvMikulska, Anna. How Russian Oil Has The Most To Gain From Iran-U.S. Crisis. Baker Institute. January 8, 2020.
xviMikulska, Anna. How Russian Oil Has The Most To Gain From Iran-U.S. Crisis. Baker Institute. January 8, 2020.
xviiRBC Thought Leadership. Navigating the 2020s. January 2020.
xviiiRBC Thought Leadership. Navigating the 2020s. January 2020.
xixJ.P.Morgan. Global Data Watch. January 10, 2020.

 

 

 

 

As uncertainty revs up, global GDP is on track to rise 3% in 2019, the slowest pace in a decade.1 Global trade volumes fell in 2019 for the first time since the Great Recession, reflecting roller coaster U.S.-China trade negotiations, a lack of progress on Brexit, and political unrest in Hong Kong and some Latin American countries. Central bankers have responded with stimulus to keep the decade-long expansion going. While low interest rates and accommodative financial conditions will likely prolong the expansion, much will depend on geopolitical influences. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

China’s exports to economies involved in the regional supply chain have continued to grow as manufacturers increased shipments to the rest of Asia.  The December U.S. announcement of the Phase One trade deal has committed China to terms on increased intellectual property protection, limits on forced technology transfer, exchange rate transparency, further opening of the financial sector, and increased purchases of U.S. goods and services.2

European growth prospects have improved after several months of stagnating, with survey data improving across both the business and consumer space. In his last meeting as the ECB president, Mario Draghi held rates unchanged. In Germany, disruptive regulations, the global trade conflict, and weakness in global car sales have been blamed for the slump in German car production.3 Data continues to show that German carmakers continue to do well globally. The U.K. Conservative election victory suggests that the withdrawal agreement legislation will likely be passed, allowing for a stable Brexit transition to begin at the end of January.

Slowdowns in China, Germany, and South Korea as well as protests in Latin America, the Middle East, and Hong Kong may be helping U.S. economy to avoid a downturn by driving investment toward America’s relatively safe harbors. The FOMC left rates unchanged at the December meeting.4 The resilience of the U.S. consumer has helped offset challenges in the factory space, thanks to a solid job market that has bolstered confidence and spending. In early December, the Phase One trade deal between China and the U.S. and the revised NAFTA were announced.

Canada’s third quarter gross domestic product data delivered an expected slowdown, as a drop in exports and drawdown in business inventories masked a rebound in domestic demand.5 Strong economic growth earlier in the year has kept the Canadian dollar in its number one spot among major currencies in 2019, supported by some of the highest yields in the G-7 and by the BOC’s reluctance to ease policy like the Federal Reserve and European Central Bank.6

In November, the S&P 500 was up 3.6%, its biggest monthly gain since June, while the S&P SmallCap 600 and the S&P MidCap 400 gained 3.1% and 3.0%, respectively. Canadian equities posted gains in November, with the S&P/TSX Composite up 3.6%. The S&P Europe 350 gained 2.8%, keeping it on track for its best year since 2009. The S&P United Kingdom joined the positive trend, gaining 1.8%, despite uncertainty caused by the pending general election. Trade optimism also helped lift Asian equities in November. U.S. fixed income performance was mixed, with leveraged loans as the top performer while Treasuries lagged. With the People’s Bank of China cutting rates in November, Pan-Asian yields ticked down and bond prices rose.

In December, we maintained the November allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Within the Fixed Income allocation, we maintained the weight of the 7-10 year maturity in order to protect the portfolio from a rebound in long rates, as treasury yields have been declining and the yield curve is close to inverted. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

We will continue to monitor the data for growth, inflation, and recession 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

 

International Monetary Fund. World Economic Outlook. October 2019.

ForeignPolicy.com. Why China Isn’t Celebrating the Phase One Trade Deal. December 18, 2019.

Trading Economics. Germany Car Production. November 2019.

Trading Economics. U.S. Fed Funds Rate. December 11, 2019.

Trading Economics. Canada GDP Growth. November 29, 2019.

Trading Economics. Canadian Dollar. November 30, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. November 30, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

Global growth continues to be weak, with the global economy impacted by the U.S.-China trade war on the one hand, and global monetary easing on the other. The trade standoff has taken a toll on business confidence, industrial production, and trade flows. It has weighed heavily on global manufacturing and hit export-oriented economies, including China, Taiwan and Korea. The trade war has had less impact on the more domestic-oriented econo­mies like the U.S. though, and as a result, there is a pronounced growth divergence among sectors and regions within the global economy. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

China’s growth slowed to 6.2% year-over-year in the second quarter from 6.4% in the first quarter, as the escalating U.S.-China trade tensions weakened business confidence and export growth.1 Emerging market economies that are less levered to the global export cycle, such as India and Brazil, have also succumbed to a slowdown in growth amidst weaker consumer spending and slow progress on reforms.

Beyond U.S.-China trade tensions, other global risks exist. Eurozone growth is slow, with Germany and Italy teetering on the edge of recession. The European Union granted the U.K. a three-month extension on Brexit, moving the deadline to January 31. The U.K. will also face a general election on December 12, adding a degree of uncertainty to future negotiations. The U.K. economy contracted in the second quarter of 2019, adding to the overall negative mood.2 Violent protests continue in Hong Kong despite a significant concession from the territory’s government in officially pulling the controversial extradition law. Growing tension in the Middle East, made worse by attacks on the Saudi oil fields, create another headwind.

Given the weak growth backdrop and elevated geopolitical risks, many global central banks have undertaken easing, aiming to stimulate growth and counter the negative effects of the trade war. At the same time, globalization appears to have increased the co-movement of government bond yields. The correlation of 10-year government bond yields in the major G7 economies increased steadily from the 1980s until 2007 and has remained high since then.3 This means that the diversification benefit from investing in foreign bond markets has fallen. With interest rates already at near or below zero in many countries, the power of monetary policy is diminished.

U.S. Real GDP grew 1.9% in the third quarter, a slowdown from 2.0% growth in the second quarter.4 A divide in the U.S. economy exists between business investment, flagging the trade war and weaker confidence and consumer spending/housing benefiting from a strong job market and the decline in longer-term interest rates. Nonfarm payrolls topped expectations with a 128,000 increase in October. Prior-month upward revisions lifted September to 180,000 and August to 219,000.5 The Bank of Canada left interest rates unchanged at 1.75% when they met on October 30. There have now been three consecutive Federal Reserve rate cuts with no matching move from the Bank of Canada, bringing U.S. overnight rates below those in Canada.6

U.S. equities posted gains in October with the S&P 500, S&P MidCap 400 and S&P SmallCap 600 gaining 2.2%, 1.1% and 2.0%. Canadian equities lost in October, with the S&P/TSX Composite down 0.9%. European equities ended the month in positive territory as the S&P Europe 350 gained 1.1% while the S&P United Kingdom declined 2.0%.

In November, we maintained the October allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth.  Within the Fixed Income allocation, we shifted the remaining balance of our 20+ year maturity treasury exposure in each of our portfolio models to the 7-10 year maturity in order to protect the portfolio from a rebound in long rates as treasury yields have been declining and the yield curve is close to inverted. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

We will continue to monitor the data for growth, inflation, and recession 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

 

1 Trading Economics, China GDP. October 18, 2019.

2 Trading Economics. United Kingdom GDP. September 30, 2019.

3 Capital Economics. Asset Allocation. October 24, 2019.

4 Trading Economics. U.S. GDP. October 30, 2019.

5 Trading Economics. U.S. Nonfarm Payrolls. November 1, 2019.

6 Trading Economics. U.S. Overnight Repo Rate. November 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. October 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.