In two of our most recent commentaries (April 10, 2015: “Our Leading Indicators Still Suggest Lower Asset Prices” and March 12, 2015: “The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices“), we discussed why Goldman Sachs’ Global Leading Indicator was giving highly misleading leading signals on the global economy given its over-reliance on components such as the Baltic Dry Index and commodity prices–both of which could be highly impacted by idiosyncratic factors such as supply disruptions or technological substitutions. Indeed, Goldman itself has been highly transparent and critical over the last six 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.
Indeed–because of these distortions–Goldman’s GLI has been highly volatile over the last six months. Last month’s GLI suggested the global economy was “contracting” from January-March 2015–which in retrospect, does not make much sense. Meanwhile, our own studies had suggested that global economic growth was still on par to hit 3.5% in 2015–while our earlier studies suggested U.S. economic growth could hit as much as 3.0%–with energy-importing countries such as India projected to accelerate to as much as 7%-8% GDP growth.
Because again of such idiosyncratic factors, Goldman’s GLI this month suggests the global economy is now moving into “expansion” mode. January data was revised and now suggests the global economy was merely “contracting” that month, with February-March barely in contraction phases. None of these make sense. The latest upbeat data is due to: rising base metals prices, a bounce in the AU$ and the CA$, and a bounce in the highly volatile Baltic Dry Index. Copper’s latest rise was arguably due to Chinese short-covering–Chinese property starts/fixed asset investments remain weak, although we are optimistic that both Chinese commercial and residential inventories are re-balancing.
Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year; more importantly, the negative momentum has not abated much (despite the re-acceleration of Western European economic growth). Specifically, we utilize a global leading indicator (called the CB Capital Global Diffusion Index, or CBGDI) where we aggregate and equal-weight the OECD leading indicators for 29 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 April 10, 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 May 2015. All four indicators are smoothed on a three-month moving average basis:
The CBGDI has also led the U.S. 10-year Treasury rate on most occasions over the last 20 years. Whenever the 2nd derivative declines to near the zero line (and continues down), U.S. 10-year Treasury rates have declined 86% of the time over the next 3, 6, and 12 months. Yes, we did enjoy a secular bull market in the U.S. long bond over the last 20 years, but 86% upside frequency is still a very good track record during a secular bull market. The track record is especially attractive considering that: 1) when this indicator was wrong, the worst outcome was a 27 bps rise (over 3 months beginning December 2004); 2) when this indicator was dead on, the best outcome was a highly-profitable, and highly-asymmetric, 168 bps decline in the U.S. long bond (over 12 months beginning December 2007).
As of this writing, the U.S. 10-year rate is trading at 2.18%, which is 14 basis points higher than the average 10-year rate of 2.04% during March 2015, when the 2nd derivative of the CBGDI essentially touched the zero line. As we discussed in past newsletters (and will further elaborate this weekend), we do not believe the ECB has lost control of the Euro Zone’s sovereign bond market. Combined with the ongoing BOJ easing, both central banks are still projected to purchase another $1 trillion of sovereign bonds over the next 12 months. With the U.S. federal budget deficit still near its lowest level over the last six years–and with the People’s Central Bank of China proactively lowering interest rates–I do not believe the U.S. 10-year Treasury rate has any room to move higher from current levels. As such, we are advocating a long position in long-dated U.S. Treasuries; our Absolute Return Liquidity strategy now has a sizable position in the long-dated Treasury ETF, TLT.