The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices

The Economist just published an article discussing the Baltic Dry Index (“BDI”) and its lack of usefulness as a global leading economic indicator. We know Goldman Sachs constructs its global leading economic indicator with the Baltic Dry Index as one of its components. To its credit, Goldman discloses this and quantifies the impact of the BDI (along with each of its other components) on a monthly basis. Over the last decade, the BDI has become increasingly volatile–first, due to the rapid industrialization of China; then the subsequent over-building of ships just as the 2008-2009 global financial crisis led to a drop in global trade.

Today, the BDI sits at an all-time low; it is down by 65% in the last 13 weeks alone. This is the major reason why we do not include the BDI as one of our leading indicators on the global economy; it is very difficult to strip out the BDI’s volatility due to fluctuations in shipping utilization, as well as idiosyncratic events such as port or iron ore mine disruptions. We prefer to utilize leading indicators that are less dependent on fluctuations in shipping utilization or commodity supply. This is why we like the OECD Composite Leading Indicators, which we incorporate into our CB Capital Global Diffusion Index (“CBGDI”).

The OECD’s Composite Leading Indicators, unlike those compiled by others, are much less dependent on commodity prices or exchanges rates of commodity currencies, i.e. the Australian dollar, the Brazilian real, the Canadian dollar, and the New Zealand dollar. Instead, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each country-specific leading indicator is fully customized depending on the particular factors driving the country’s growth.

To recap, the CBGDI is constructed by aggregating and equal-weighting (on a 3-month moving average basis) the OECD leading indicators for 30 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall in November 1989. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index sightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

We first introduced our CB Capital Global Diffusion Index (“CBGDI”) in our March 17, 2013 commentary (“The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices“), when WTI crude oil traded at $93 a barrel. Based on the strength in the CBGDI at the time, we asserted that WTI crude oil prices have bottomed, and that WTI crude oil is a “buy” on any further price weakness. Over the next six months, the WTI crude oil spot price would rise to over $106 a barrel.

We last discussed the action of our CBGDI in our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). At the time, we mentioned that–due to the strength in the CBGDI–WTI crude oil prices will likely rise in 2015. We obviously were early on that call as: 1) OPEC subsequently refused to cut production leading to the “Valentine’s Day Massacre” in global oil prices, and 2) the supply of U.S. shale oil continued to rise despite lower prices (a trend that is now ending).

Even though both the 1st and 2nd derivatives of the CBGDI are still positive, they are beginning to flash ‘caution’ signals. For example, the 2nd derivative of the CBGDI just declined below its 1st derivative–which in the past has led to a slowdown or even a major downturn in the global economy (as well as global asset prices). Note the following monthly chart shows the year-over-year % change in the CBGDI and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from January 1994 to March 2015. All four indicators are smoothed on a three-month moving average basis:

OECDJanuary2015Despite the recent weakness of the CBGDI, however, the historic divergence between the CBGDI and WTI crude oil prices suggest that the latter is bottoming. The case for higher crude oil prices is compounded by the fact that U.S. shale oil production growth is now stagnating (which we discussed in our recent weekly newsletters, and just confirmed by the Energy Information Administration). Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel, there will be significant opportunities on the long side of the commodity.

With the CBGDI expected to weaken further this year, we also do not believe the Fed should hike rates anytime soon (even a one-time 25 basis point hike)–especially given the recent strength in the U.S. dollar. A Fed rate hike will be counter-productive as it will simply reduce U.S. dollar/global liquidity at a time of global risk-aversion and reduced economic activity. We thus remain cautious; we will mostly sit on the sidelines until one of the following occurs: 1) global liquidity increases, 2) the CBGDI begins to turn up again, or 3) global asset prices correct by more than 10% from current levels.

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