In our March 12, 2015 commentary (“The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices“), we discussed the shortcomings of Goldman Sachs’ Global Leading Indicator (GLI) based on its over-reliance on various components such as the Baltic Dry Index and commodity prices & currencies (specifically, the AU$ and the CA$). To Goldman’s credit, the firm has been highly transparent and vocal over the last several months about the distortions created by an oversupply of dry bulk shipping capacity and an impending wall of additional supply of industrial metals, such as copper and iron ore.
Goldman Sachs thus recognized that the GLI’s downturn in December last year (by that time, the bear market in oil and metals prices were well under way) was providing misleading cyclical signals of the global economy, with the exception of certain economies such as Australia, Canada, Brazil, and Russia. Indeed, our own studies suggest that global economic growth was still on par to hit 3.5% in 2015–with U.S. economic growth hitting 3.0%–while energy-importing countries such as India would actually experience an acceleration to 7%-8% GDP growth.
That being said, Goldman’s GLI remains highly instructive. Since December, other components of the GLI have begun to exhibit weakness that is consistent with a contraction of the global economy. Components exhibiting significant weakness include global industrial survey data (PMI), as well as new orders to inventory data (NOIN). Countries exhibiting significant weakness include the U.S., China, Norway, Japan, Turkey, and surprisingly, India. Meanwhile, Germany, France, and Italy are experiencing industrial production growth–likely due to the declining euro and record-low borrowing rates.
In a nutshell, our latest studies are now finally confirming Goldman’s GLI readings (a high probability of a global economic contraction). In our March 12 commentary, we asserted that global asset prices (especially equity prices) are poised to experience a +10% correction, given the weakness in the readings of the CB Capital Global Diffusion Index (the CBGDI).
The CBGDI is constructed differently in that we aggregate and equal-weight the OECD leading indicators for 30 major countries, including non-OECD (but globally significant) members such as China, Brazil, Turkey, India, Indonesia, and Russia. The OECD’s Composite Leading Indicators possess a better statistical track record as a leading indicator of global asset prices and economic growth. Instead of relying on the prices of commodities or commodity currencies, 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 of the OECD’s country-specific leading indicator is fully customized depending on the particular factors driving a country’s economic growth.
The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. 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 leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators). Since we last discussed the CBGDI on March 12, the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices. Figure 1 below is a monthly chart showing the year-over-year % change in the CBGDI, along with the rate of change (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 April 2015. All four indicators are smoothed on a three-month moving average basis:
With the 2nd derivative of the CBGDI declining further from last month’s reading, we believe the global economy is very vulnerable to a major slowdown, especially given the threat of a Fed rate hike later this year. We believe two or more Fed rate hikes this year will be counter-productive, as it will reduce U.S. dollar/global liquidity even as many Emerging Markets economies are struggling with lower commodity prices and declining foreign exchange reserves. We also remain cautious on global asset prices; we will mostly sit on the sidelines (or selectively hedge our long positions with short positions on the market) until one of the following occurs: 1) global liquidity increases, 2) the 2nd derivative of the CBGDI begins to turn up again, or 3) global risk asset or equity prices decline by +10% from current levels.
We will look to selectively purchase energy-based (i.e. oil, natural gas and even coal) assets given the historical divergence of the CBGDI and WTI crude oil/natural gas prices. We continue to believe that U.S. shale oil production is topping out as we speak. Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel (or if the U.S. Henry Hub spot price declines below $2.50/MMBtu), there will be significant opportunities on the long side in oil-, gas-, and even coal-based assets.