Groundhog Day

Friday’s plunge in the Dow seems to have finally rattled the complacency that has persisted in the equity markets for the past year.  Whether this is just a pause for the markets to catch their breath or the beginning of something more sinister, no one has a clue.  

What I found intriguing is that the “jarring” 2.5% decline (remember when a 20% drop in one day was considered life changing?) occurred on Groundhog day.  This seemed appropriate both in context of Punxsutawney Phil’s call on the beginning of spring and in context of the movie bearing its name.  

Up until this week, the last year has reminded me of the movie Groundhog Day, the one with Bill Murray where he is trapped living the same day over and over again.  In the market’s version, every day the equity investor goes to work and starts buying stocks in response to hearing that in addition to a global economy that is strengthening, the US tax cuts will immediately boost earnings, incite massive repatriation that will spur buy-backs, dividend increases and all sorts of manna from heaven.  Over the course of the day, this buying pushes the indices higher and the investor goes home.  The next day, it is tableau rasa, groundhog day all over again.  The investor goes into work the next day, with the indices at a higher level and hears for the first time that US tax cuts will be great for earnings and repatriation of foreign profits by US companies will rain cash down on the market and that the global economy is gathering steam.  Investors have to get on board, so they start to buy equities, regardless of valuations, pushing the averages higher again.  The investor then goes home, and then gets up and goes to work the next day and he hears for the first time exciting news about the impact of tax cuts and the global economy…You get the picture.

I know the market is suppose to be a forward-looking discounting machine, but is it possible the degree of good news being priced into global equities was overdone while participants seemingly were locked into an infinite loop with the same factors getting rediscounted again and again?

It is now possible that from these elevated equity valuations, there has been a subtle shift away from the sweet spot.  The good news of global economic growth mixed with ample materials for financial engineering that for the last year have signalled all systems ‘go’ may now be interpreted as increasing the risk of higher yields and hence lower expected discounted future earnings. All of a sudden, good news maybe not that good after all.  

Last Friday, up on Gobbler’s Knob, Punxsutawney Phil came out of his hole to be greeted by a perfect cold morning.  With no clouds to protect him from the rising sun, he was startled by seeing his shadow and scurried back into his abode, the omen being we are in for a long winter.

On the same day, at 8:30 am, the market poked its head out to see the US employment release.  The news was good and the resulting possibility of higher-than-expected yields startled the market and sent it reeling back under its desk.  Now we just have to figure out if this means a long winter ahead for the market as well.  Happy Groundhog day.  

    

Party On

I really don’t have a life, so for the last few days I have been reading and listening to what government elites and industry titans have been saying at the World Economic Forum in Davos.  You can’t help but feel that most of these participants are almost giddy about the current state of the world.  Global growth is healthy and synchronized and probably most important to these attendees, the markets are soaring around the world.  And with the implementation of US tax changes expected to spur business investment over the near future, many pundits see stocks only going higher regardless of their starting point.

Through headlines, we were reminded by Mr. Dalio of Bridgewater and Mr. Fink of Blackrock that despite the tripling of the S&P since the depths of the great recession, there continues to be ridiculous amounts of liquidity on the sidelines that could potentially be deployed into markets.  Fink told Bloomberg News that in some countries in Europe, around 70% of people’s savings was still held in their banking accounts.  Imagine, he said, if that moved into his business sphere (stocks and bonds) and imagine what that would do to help reduce inequality as these people benefited from rising markets.  (I will give you a moment to gag).  Mr. Dalio suggested that there was a risk we could see a “melt-up” in markets as cash moved in from the sidelines.  He feared that institutions and people left holding cash would feel stupid.  

The only real risks mentioned that could derail these extremely bullish forecasts seemed to be an unanticipated acceleration of inflation or a mistake made by central banks as they try to re-calibrate monetary policy to stronger real growth in highly levered economies.  If rates rise too quickly, all bets are off.

Would one dare suggest that the policy makers may have already made their mistakes?  That the reason for the near euphoria around markets evident at this gathering is because of the sugar rush provided by policy makers when they earlier added three sugar cubes instead of the one that was needed?  A global economy at or near full employment with American fiscal policy soon to kick in does not seem like appropriate, well-timed policy.  A world awash in cash that might yet be put to work in already overvalued equity markets does not seem to be well calibrated global monetary policy.  But these “mistakes” have resulted in an overabundance of “positives”.  What’s there not to like?

It’s the next mistakes that will now have to hurt even more.    

January MPR: No Change, Still Dovish

The Bank raised its benchmark interest rate this week, as many in the market expected.  More surprisingly, the tone from the documents and the press release seemed aligned with market expectations. In the press conference, the Governor seemed pretty pleased with how things evolved, saying the market digested the firmer data as it was released and repriced itself on an ongoing basis, allowing the Bank to ratify the analysis with its increase in the target rate.  That is how it is suppose to happen, he said, when the Bank is data dependent.  

There was nothing that truly stood out from the MPR document.  NAFTA continues to be the fly in the ointment.  The uncertainty surrounding the outcome of the negotiations is already putting a damper on trade and business investment, subduing aggregate demand from where it could be and potentially having a longer-term negative impact on the economy’s capacity to produce.  If the US decides to pull itself out of the negotiations, then all bets are off with respect to the outlook.    

All said, the Bank’s forecast was relatively optimistic, with growth remaining firm and then gradually slowing down to around potential by 2019.  Although the contributors of growth do shift, the overall economy appears to have momentum and be on a firm basis.  The risk to the positive outlook is an exogenous shock. Something like the US pulling out of NAFTA.  

The Governor tried to get ahead of the market, fearing that it may start trading off of Nafta headlines, creating unnecessary volatility by indicating that the Bank would not view this as a binary event. He is right that the decision is not binary.  It will not have a significant immediate impact on the real economy.  Just because one of the participants decides to opt out, the trading world will not cease to exist.  It will potentially take years before the trade framework that replaces NAFTA will be settled on.  But in the meantime, the market will of course remain vulnerable to NAFTA headlines and, being forward looking, will rightfully react on any news as any post-NAFTA trade regime will be sub-optimal to the current one and need some degree of additional monetary stimulus. 

In addition to the NAFTA headlines which will keep risks to front end rates to the downside, there was other evidence that the Bank remains dovish.  They continue to seek reasons to justify not being as aggressive as a pure read of the output gap and the data would suggest.  Governing Council continues to want to believe that we are now in a sweet spot where stronger demand leads to greater supply with increased investment, more business creation and new hires.  They seem to want to let this run as far as they can.  They have come up with a new and improved measure of wage growth, wage-common, that just happens to show that wage growth is slower than normally reported and that the best determinant of this new measure is labour slack.  The fact that this measure is running just above the rate of inflation suggests to them that slack continues to exist. And finally, to stress that point, the Governor again at the press conference defied the analysis of many and said he was still preoccupied with Karim holed-up in his parents’ basement unable to get that job in management.

When you add all of this to their concern about the sensitivity of the leveraged household sector to higher rates, you have a central bank that seems willing to be extremely patient.  It will take some sharp upward surprises for both wages and their core measures before anything close to a hawkish bent makes its way into the building.       

The End of Judgement Days?

Here we go again with the set up for more confusion between the market and the Bank of Canada.  It should be simple.  With core measures of inflation firming at 1.7%, an incredibly strong monthly jobs report diminishing already little remaining excess capacity in the labour market and an economy already at full capacity, it should be a lay-up to expect an inflation targeting central bank that says they are data dependent to nudge rates higher at their next meeting. I know they said they would be cautious when raising rates but surely this is enough, even for this Governor.  

The market has learned over the last few months that Bank action is not strictly data dependent but instead heavily judgement dependent.  The heavy reliance on judgement, we are told, is to allow Governing Council to fill in the blanks caused by the many “uncertainties” that their models just can’t capture.  And so here we are with increasing risks to inflation from a labour market blasting away and about to feel the effects of higher minimum wage legislations, with oil above $60 and with the US economy about to get a fiscal boost, but at the same time with Governing Council having to deal with the same “uncertainties” and structural issues they consistently point to that may dramatically temper any future inflationary impulses.  Nafta could still get pulled, accumulated household debt could adversely impact consumption, OSFI’s new mortgage rules could still flatten the housing market, and, probably coming soon, the legalization of pot could potentially lower productivity (but no one will care).  But besides all these “what ifs”,  this Governor could keep the Bank on the sidelines for the simple reason that youth unemployment did not fall last month….Karim is still in his parents’ basement! 

At some point, however, you would think that the Bank’s own credibility as a forward looking, data dependent inflation targeting central bank will become more at risk.  How far can they push their reliance on their “go-to” list of uncertainties that allow them to justify a level of monetary accommodation that looks more and more targeted to only a few select slices of the economy.  I believe the Governor, in his noble zeal to be the hero of main street is risking giving many people the impression that he is either targeting the currency or unemployment rather than what he is mandated to do.

The Bank, for its own credibility, needs to move rates higher in January.  Responding in a timely and consistent manner to the data will reassure the market that the Bank remains committed to its inflation targeting mandate.  This acknowledgement that risks to inflation have increased and are being addressed will ultimately give the Bank the needed trust from the market to implement appropriate policy that will achieve their 2% inflation target and ultimately get Karim into a management position. 

Sleepless in Ottawa

When I started this particular post, I was going to address the Governor’s latest speech that described the three things that keep him up at night.  But then along came today’s year-end interview with the Governor in the Globe.  

As per his speech on being sleepless in Ottawa, it struck me that this poor sap is never going to get a full night of REM while he is acting as chief money creator.  For those of you with a life, meaning you missed what he said, the three main concerns he has are cyber threats, high house prices with the associated household debt, and the tough job market for young adults.  His problem beyond apnea is that he will never be able to change the situation.  Casting cyber threats aside, keeping rates at ridiculously low levels to encourage young Karim to tear himself away from a parent’s cooking and laundry service and enter into the workforce will only exacerbate his nightmares about house prices and debt.  Obviously, raising rates to help on the financial stability side will ruin the rest of Karim’s career life.    

The only proper response is a Cpap machine, more Ny-quil and for him to listen to his own advice.  As the Governor himself said in this week’s Globe article, “We said it all along:  we have one instrument - interest rates, and one target - inflation.  All other stuff people would like us to control is not actually our job.  It is a side effect.”  He could have skipped the speech.    

But as I said above, the Globe article stopped me in my tracks.  The piece makes it clear that the he and the market are not seeing eye to eye these days.  He is just as frustrated about communication with the street as the street is with him.  Apparently his shift from forward guidance, where the central bank lays out its intensions over the near term to his “risk management” framework (whatever the hell that is) has not gone as smoothly as he would like.  It has been difficult to shake the market of their habit of expecting him to tell them what to think, while at the same time providing the market the information they need to think for themselves. 

This touched a nerve.  For a long time, this central bank has told the market the framework they use to make policy decisions.  Recently the Senior DG laid out in a speech in New York the sausage-making process that relies heavily on their many models and then adds a few dashes of judgement to address any uncertainties.  The market has access to the same prime ingredients, the incoming data which describes aggregate demand,  the Bank’s latest opinion of the economy’s potential and the objective of the Bank, which is to achieve the 2% inflation target over the medium term.  With all of that, sans forward guidance, the market can make a reasonable forecast of what the Bank will do next, if the Bank itself adheres to the same framework based on quantitative observations.

What the market cannot do is read minds and guess what spices the Colonel is putting into the bucket for this picnic.  According to the article, every decision is now tableau rasa, where they build each statement from the ground up and address areas of uncertainty with their judgement.  Because of the high number of risks and uncertainties in the current environment, there is an inordinate amount of judgement being applied, too much for the market to have a fair chance at guessing what is next.  

The quote above says that the Bank should only be concerned about the inflation target and all the other stuff is not their worry.  So why the long face at Governing Council meetings about Karim, our basement-trapped young adult?  How was the market, from the framework taught to it, to know that GC would suddenly think it is the Bank’s responsibility to keep policy extremely accommodative to give this one select group a little more time to move on up.  It’s not lack of forward guidance or adjusting to a “risk management” approach (whatever the hell that is) that is causing the problem, it is lack of discipline on the part of the Bank as to their own policy framework.

But wait, there’s more.  In the article, the Governor seems to bristle over the fact that the market “over-read” the word “cautiously” in their statement, appearing to think this was a code word for no move.  These market people are such simpletons as “it’s only language” after all.   But how are the simpletons suppose to put that word in context when it is followed up by statements, included in this article, that say the “potential to slip into a deflationary scenario is much more preoccupying.  We need to get ourselves up there for real, and to the 2% zone, so we have room to manoeuvre for the next shock that comes along.”  I admit my simpleton status, but that would suggest to me as long as the Governor doesn’t think 1.6% core inflation is “up there” near 2%, then the hurdle is extremely high to start moving on rates.  Just sayin’. 

All is not lost.  Apparently the Governor believes that the market is finally coming around to better understanding his risk management approach.  He cites the September rate hike when, according to Bloomberg, the bond market had priced in a 50:50 chance of a hike following the release of extremely strong economic numbers just several days ahead of the decision.  He asks out loud how on earth the market could have got it right if the Bank had not been communicating clearly.  I don’t even know where to start with his conclusion.  I would suggest that the market did get it right despite their communication.  The 50:50 odds tell me the market figured out that in this new “risk management” approach (whatever the hell that is), the economic numbers don’t really matter and it’s a toss up as to what this guy will do next. Should make for an interesting New Year.  

I will admit that after reading this article, I have added one more thing that keeps me up at night.

Judgement Days

This week the Bank affirmed its commitment to a cautious, some would say dovish approach to monetary policy.  They made it clear that although interest rate increases will likely be required, they will be executed with caution with an eye on incoming data that will allow the assessment of the economy’s sensitivity to higher rates, the evolution of capacity and the dynamics of wage growth and inflation.   

A large part of their press release was good news.  Synchronized global growth is occurring and domestic growth is moderating but is expected to remain above potential for the second half of the year.  The domestic output is being driven by “very strong” employment growth, increases in wages, higher levels of government spending, and continued business investment.  On the downside, exports are not pulling their weight and housing is adjusting.  As per their target, inflation is higher than expected and even core is firming.  In the past, many of us have seen central banks raise rates after rattling off positive facts like that, particularly when we have been told that we are at or close to full capacity.  

The Bank again said its policy actions will be data dependent but then shows us that it isn’t.  I can’t imagine a tougher time for central bank watchers in this country than now.  Both the Bank and the market see the data at the same time, but the market has no idea how that data will be assessed, weighed by “judgement” that seems contrived to be consistent with GC’s gut feeling. Looking at the preponderance of facts would suggest that we are at at full capacity and at unemployment levels consistent with full employment, seeing wages finally getting some traction and observing the participation rates climbing. This could, at the very least, suggest dropping the cautious stance. But drawing this conclusion from looking strictly at the data is insufficient to align with the Bank’s assessment.  Don’t let facts get in the way of a good story.  In their judgement, there is still ongoing slack in the labour market. Keep the foot on the accelerator.   

Another example is the press release points out that upward revisions to historical national accounts data have left output at a higher level than expected, but their assessment is that this has had no effect on the output gap as the revisions imply the economy’s potential moved up commensurably.  I guess in their judgement, lags between when potential is impacted from any increases in aggregate demand is pretty much simultaneous.  My judgement would be that it is unlikely that newIy hired employees and recently deployed capital would contribute to increasing the country’s potential at the same rate as aggregate demand is moving but my judgement doesn’t matter, only GCs.  This revised data will only give them ammunition to increase potential and move the stop sign further down the road, alluding to my last blog entry. 

Until we decisively break from this period of economics behaving badly (questioning the Phillips curve, the low inflation mystery, uncertainty around trade, etc, etc), the market will continue to be at a high risk of being upended by this central bank.  The Bank tells us that they will be data dependent, but rightly or wrongly, in the current environment, the Bank is instead applying liberal doses of judgement to that data.  So for now, the incoming data should not be viewed as creating a defining, clear landscape picture but should be viewed as an abstract piece of art.  Everyone will look at the same canvas but walk away with a different interpretation.  As the data comes out, feel free to look at the facts and make your own assessment of how the economy is responding to higher rates (is housing slowing due to higher rates or macro prudential measures?), how capacity is evolving and look at the dynamics of wage growth and inflation but whatever conclusions you reach will be your assessment and unlikely to tell you anything about what GC is thinking and is about to do. 

December's Decision

After last Friday’s employment and output data releases, I wonder if the Bank is relieved that the upcoming policy decision is not an MPR.  A few words of acknowledgement here and there in the press release and they can leave rates unchanged.  Nothing to see here, folks.  But I would hope that in the hallowed halls there is a recognition that it just got harder to justify their cautious approach to raising rates by overemphasizing the risks of what might happen versus weighing what is happening.  To remain dovish suggests that the downside risks to future economic performance from potential trade and announced macro prudential measures must have increased to offset any increase in upward price pressures coming from the actual persistent expansion of the economy.  I don’t believe that you can make a solid case that the potential negative impact from these two measures has become more likely or that their outcomes will be worse than previously envisioned a few weeks ago.  What we do know is that if the worse unfolds, the economy will be dealing with these issues from a higher starting point which should give policy makers some comfort.

I think back to the many analogies that the Bank has used; from walking the dog, to cooking spaghetti sauce, to sailing without navigation equipment, to driving a car.  Remember how when you are driving and see a stop sign ahead, you don’t jam on the brakes, you carefully pump the brakes and come to a gentle stop at the intersection.  The Bank was going to appropriately raise rates to slow the economy so that inflation would nestle into the 2% level.  But what do you do if you are so preoccupied by possible collisions that may happen beyond the intersection that you forgot to break appropriately and you now find yourself either in the intersection or through it.  I suppose mere mortals have two choices.  You can now brake and end up somewhere beyond where you were suppose to be or you can keep your foot on the accelerator and continue on in hope that one of the events that you were worried about occurs and is able to slow you down without causing too much damage to the car.  But a central bank is not a mere mortal so the choice most likely to be taken is to convince the market that the intersection was never where the Bank said it was.  You keep telling people that the stop sign is further up the road, so its okay to keep the pedal to the medal and not to worry, that the brakes will be applied at the appropriate time. 

This sounds to me like an accident in waiting.