Revising Our 2017 Outlook on U.S. Treasuries: From 2.25% to 2.50% on the 10-Year

In our earlier 2017 outlook on the U.S. 10-year Treasury yield published on December 21, 2016 (see “Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year“), we argued that the U.S. 10-year Treasury yield will close at around 2.25% at the end of 2017. Our target at the time was very much out-of-consensus, as most analysts (including those from Goldman Sachs, Morgan Stanley, and PIMCO) were expecting the 10-year to rise to 2.75% or above, driven mostly by late-cycle inflationary pressures and the promise of U.S. corporate tax cuts and a $1 trillion infrastructure spending package by the Trump administration.

Since the publication of our 2017 outlook on the 10-year Treasury, U.S. economic growth has disappointed, with the “advance” estimate of U.S. Q1 2017 real GDP growth hitting an annual rate of just 0.7%. As a response, the U.S. 10-year yield sank to a trough of 2.18% on April 18, before rebounding to a close of 2.33% earlier tonight.

Figure 1 below shows our timing calls as discussed in our weekly global macro newsletters on the U.S. 10-year from June 2015 to the present. Note that prices of the 10-year Treasury rise as yields decline.

us10year

Instead of our previous target of 2.25%, I now expect the U.S. 10-year Treasury yield to rise steadily from 2.33% today to around 2.50% by the end of this year. Note this target is still slightly out-of-consensus (e.g. Goldman Sachs is expecting the 10-year to rise to 3.00% by the end of this year). Given the still-uncertain U.S. political outlook, I am looking for significant, tradeable volatility on the 10-year for the rest of this year; on a net basis, however, I believe there will be an upward bias on the 10-year yield for the following reasons:

  • When our earlier 2017 outlook was published on December 21, 2016, speculators were holding a record short position on U.S. 10-year futures with the exception of a brief period in early 2005. An ensuing rally in the 10-year (a decline in yield) developed as a result; as of this writing, however, the net speculative position on U.S. 10-year futures has reversed dramatically from that of five months ago. In fact, net speculators’ bullish bets rose earlier last week to their highest levels since early 2008. From a contrarian standpoint, this should put downward pressure on the 10-year Treasury–in turn resulting in higher yields;
  • In our April 30, 2017 newsletter (email me for a copy), we switched from a “neutral” to a “bearish” positioning on German/French sovereign bonds, as: 1) after experiencing a near-Depression during the 2011-13 period, European economic growth was finally accelerating, and 2) ahead of the May 7th French run-off vote between Macron and Le Pen, it was clear that European political risk was dissipating. In fact, European forward rates at the time were showing a 60% chance of an ECB rate hike in March 2018. An acceleration in European economic growth is also being confirmed by the latest readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”), as seen in Figure 2 below.

CBGDI.png

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last time I discussed the CBGDI on this blog was on May 12, 2016 (“Leading Indicators Suggest Further Upside in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led 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%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve after making a trough in late 2015/early 2016  (see Figure 2 above). Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in many cases, an acceleration (e.g. the economies of Austria, Canada, Denmark, France, Germany, Norway, South Korea, New Zealand, Brazil, and Russia ) in global economic activity. With Chinese RMB and capital outflows having stabilized in recent months, global economic growth around the world seems to be synchronizing. This should lead to higher U.S./German/French sovereign rates from now till the end of 2017.

The Coming Breakthroughs in the Global Supercomputing Race

In our August 31, 2015 article (“The U.S. Needs to Rejuvenate the Global Supercomputing Race“), we expressed our concerns regarding the state of the global supercomputing industry; specifically, from a U.S. perspective, the sustainability of Moore’s Law, as well as increasing competition from the Chinese supercomputing industry. Below is a summary of the concerns that we expressed:

  • Technological innovation, along with increasing access to cheap, abundant energy, is the lifeblood of a growing, modern economy. As chronicled by Professor Robert Gordon in “The Rise and Fall of American Growth,” U.S. productivity growth (see Figure 1 below; sources: Professor Gordon & American Enterprise Institute)–with the exception of a brief spurt from 1997-2004–peaked during the period from the late 1920s to the early 1950s; by 1970, much of today’s everyday household conveniences, along with the most important innovations in transportation & medicine, have already been invented and diffused across the U.S. Since 1970, almost all of the U.S. productivity growth could be attributed to the adoption and advances in the PC, investments in our fiber optic and wireless networks, along with the accompanying growth of the U.S. software industry (other impactful technologies since the 1970s include: the advent of hydraulic fracturing in oil & gas shale, ultra deepwater drilling in the Gulf of Mexico, as well as the commercialization of alternative energy and more efficient battery storage systems, as we first discussed in our July 27, 2014 article “How Fracking Saved the U.S. Economy“). This means that a stagnation in the U.S. computing or communications industries would result in an invariable slowdown in U.S/global productivity growth;

americanproductivitygrowth

  • The progress of the U.S. supercomputing industry, as measured by the traditional FLOPS (floating-point operations per second) benchmark, had experienced a relative stagnation when we last wrote about the topic in August 2015. E.g. in 2011, both Intel and SGI seriously discussed the commercialization of an “exascale” supercomputer (i.e. a system capable of performing 1 x 10^18 calculations per second) by the 2019-2020 time frame. As of today, the U.S. supercomputing community has pushed back its target time frame of building an exascale supercomputer to 2023;
  • At the country-specific level, the U.S. share of global supercomputing systems has been declining. As recent as 2012, the U.S. housed 55% of the world’s top 500 supercomputing systems; Japan was second, with 12% of the world’s supercomputing systems, with China (8%) in third place. By the summer of 2015, the U.S. share of the world’s top 500 supercomputing systems has shrunk to 46%, although both Japan and China remained a distant second at 8%. Today, the Chinese supercomputing industry has led an unprecedented surge to claim parity with the U.S, as shown in Figure 2 below.

Figure 2: China – Reaching Parity with the U.S. in the # of Top 500 Supercomputerstop500

Since the invention of the transistor in the late 1940s and the advent of the supercomputing industry in the 1960s, the U.S. has always been the leader in the supercomputing industry in terms of innovation, sheer computing power, and building the customized software needed to take advantage of said supercomputing power (e.g. software designed for precision weather forecasting, gene sequencing, airplane and automobile design, protein folding, and now, artificial intelligence, etc.). With U.S. economic growth increasingly dependent on innovations in the U.S. computing industry and communications network–and with China now threatening to surpass the U.S. in terms of supercomputing power (caveat: China’s HPC software industry is probably still a decade behind)–it is imperative for both U.S. policymakers and corporations to encourage and provide more resources for the U.S. to stay ahead of the supercomputing race.

Unlike the tone of our August 31, 2015 article, however, we have grown more hopeful, primarily because of the following developments:

  • Moore’s Law is still alive and well: At CES 2017 in Las Vegas, Intel declared that Moore’s Law remains relevant, with a second-half target release date for its 10 nano-meter microprocessor chips.  At a subsequent nationally-televised meeting with President Trump earlier this month, Intel CEO Brian Krzanich announced the construction of its $7 billion Fab 42 in Arizona, a pilot plant for its new 7 nano-meter chips. Commercial production of the 7nm chips is schedule to occur in the 2020-2022 time frame, with most analysts expecting the new plant to incorporate more exotic technologies, such as gallium-nitride as a semiconductor material. The next iteration is 5nm chips; beyond 5 nano-meters, however, a more fundamental solution to extend Moore’s Law will need to occur, e.g. commercializing a graphene-based transistor;
  • GPU integration into supercomputing systems: The modern-day era of the GPU (graphics process unit) began in May 1995, when Nvidia commercialized its first graphics chip, the NV1, the first commercially-available GPU capable of 3D rendering and video acceleration. Unlike a CPU, the GPU is embedded with multiple threads of processing power, allowing it to perform many times more simultaneous calculations relative to a CPU. Historically, the supercomputing industry had been unable to take advantage of the sheer processing power of the GPU, given the lack of suitable programming languages specifically designed for GPUs. When the 1.75 petaflop Jaguar supercomputer was unveiled by Oak Ridge National Laboratory in 2009, it was notable as Jaguar was one of the first supercomputers to be outfitted with Nvidia GPUs. Its direct successor, the 17.59 petaflop Titan, was unveiled in 2012 with over 18,000 GPUs. At the time, this was a concern for two reasons: 1) hosting over 18,000 GPUs within a single system was unprecedented and would doom the project to endless failures and outages, and 2) there were too few programming codes to take advantage of the sheer processing power of the 18,000 GPUs. These concerns have proven to be unfounded; today, GPUs are turning home PCs into supercomputing systems while Google just rolled out a GPU cloud service focused on serving AI customers;
  • AI, machine-learning software commercialization: Perhaps one of the most surprising developments in recent years has been the advent of AI, machine-learning software, yielding results that were unthinkable just five years ago. These include: 1) Google DeepMind’s AlphaGo, which defeated three-time European Go champion Fan Hui by 5-0 in 2015, and finally, the world Go champion Ke Jie earlieir this year, 2) Carnegie Mellon’s Libratus, which defeated four of the world’s top poker players over 20 days of playing, and 3) the inevitable commercialization of Level 5 autonomous vehicles on the streets of the U.S., likely by the 2021-2025 time frame. Most recently, Microsoft and the University of Cambridge teamed up to develop a machine learning system capable of writing its own code. The advent of AI in the early 21st century is likely to be a seminal event in the history of supercomputing;
  • Ongoing research into quantum computing: The development of a viable, commercial quantum computer is gaining traction and is probably 10-20 years away from realization. A quantum computer is necessary for the processing of tasks that are regarded as computationally intractable on a classical computer. These include: 1) drug discovery and the ability to customize medical treatments based on the simulation of proteins and how they interact with certain drug combinations, 2) invention of new materials through simulations at the atomic level. This will allow us to build better conductors and denser battery systems, thus transforming the U.S. energy infrastructure almost overnight, and 3) the ability to run simulations of complex societal and economic systems. This will allow us to more efficiently forecast economic growth and design better public policies and urban planning tools.

Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year

Last year at around this time, we published our 2016 outlook on the 10-year Treasury yield (“Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year“). To recall, we model our 10-year Treasury yield expectations with the following “building blocks” model:

10-year Treasury Yield = expected 10-year U.S. inflation + expected U.S. real GDP growth + global central bank purchases (including U.S. QE) + geopolitical premium

Note that the current “arbitrage” between the German & Japanese 10-year (typically done with a “dirty hedge” by hedge funds) with the U.S. 10-year is being taken into account in the above model, to the extent that ECB and BOJ purchases are driving such hedge fund “arbitrage” activity.

The reasoning behind our 2016 outlook of 2.5% (the 10-year is trading at 2.54% as of this writing) included: 1) higher U.S. inflation driven by the combination of a tightening U.S. job market, rising U.S. housing prices, and higher healthcare costs, and 2) the peaking of certain deflationary effects around the world, e.g. Chinese CPI was no longer declining while fears surrounding a larger-than-expected Chinese yuan devaluation would turn out to be unfounded.

Figure 1 below shows our timing calls on the U.S. 10-year from June 2015 to the present (note the prices of the 10-year Treasury rise as yields decline).

10yeartreasury2016

For 2017, I am targeting a 2.25% rate on the U.S. 10-year yield. The target is slightly out-of-consensus (Goldman, Morgan Stanley, and PIMCO are all expecting the 10-year to rise to 2.75% or above). The outlook, however, is very uncertain and I am again looking for significant (tradeable) volatility on the 10-year in 2017; by and large, however, I believe the factors that will drive the 10-year yield lower slightly outweigh the bearish factors on the 10-year:

  • As of this writing, speculative shorts on the U.S 10-year futures are–with the exception of early 2005–at their highest level since the collection of COT records beginning in 1992. From a contrarian standpoint, this should provide some short-term support for the 10-year (in turn resulting in lower yields);
  • Much of the recent up-move in the U.S. 10-year yield occurred after the U.S. presidential election as investors speculated on a combination of higher growth and higher inflation, driven by the promise of: U.S. corporate & personal income tax cuts, a promised $1 trillion infrastructure spending package by President-elect Trump, potential repeal of the ACA and Dodd-Frank along with a myriad other U.S. “regulatory burdens.” As a reminder, however, this is all conjecture at this point. The Republicans are likely to pass their promised corporate & income tax cuts and to repeal the ACA through the reconciliation process (this is needed to avoid a Senate filibuster by the Democrats). However, such tax cuts passed through the reconciliation process needs to be revenue-neutral. Even with the potential to use “dynamic scoring” (where it is assumed lower taxes will result in higher GDP growth in order to offset some of the tax revenue lost), a significant part of the promised tax cuts will likely be scaled back in order to meet fiscal budget targets. E.g. The much discussed 15% or 20% statutory corporate income tax rate will likely be revised to 25%;
  • In the long-run, the U.S. economy is still limited by the combination of slowing population growth (the current 0.77% annual population growth rate is the lowest since the 1930s), older (and less productive) demographics, and a potential stall in immigration–the latter of which has historically benefited the U.S. disproportionately (immigrants are twice as likely to be entrepreneurs than native-born Americans). Another historic tailwind for the U.S. economy actually peaked in 1999: women participation in the labor force has trended down since 2009.

Unless productivity growth jumps over the next several years (not likely; the “fracking revolution” was the last enabler of U.S. productivity growth), the U.S. economy is likely to stall at 2% real GDP growth, especially given the recent 14-year high in the U.S. dollar index–which will serve to encourage import growth and restrict export growth. Note this outlook assumes that the long-term U.S. inflation outlook remains “well-anchored” at 2.0%–should the U.S. Congress adopt a more populist outlook (i.e. higher fiscal spending that is likely to be monetized by the Fed in the next recession), then the 10-year could easily surpass 3.0% sometime in 2017.

Why China Will Not Cut Rates Any Further This Year

In response to a slowing property market, lower consumer spending growth, and a slowing global economy, the People’s Bank of China (PBOC) has cut its one-year policy rate five times and its reserve requirement ratio three times over the last 12 months. Last November, the PBOC’s one-year policy rate sat at 6.00%–today, it is at 4.60%. Moreover, the PBOC’s cut in its reserve requirement ratio–from 20.0% to 18.0% since February–has released more than $400 billion in additional liquidity/lending capacity for the Chinese financial system.

I believe Chinese policymakers will maintain an easing bias over the next 6-12 months given the following:

  1. As I discussed a couple of years ago, a confluence of factors–including China’s debt build-up since the 2008-09 global financial crisis, slowing population growth, as well as natural limits to an export- and CAPEX-driven growth model–means China’s real GDP growth will slow to the 5%-8% range over the next several years. Consensus suggests that China’s real GDP growth will be lower than the official target of 7% this year. Given China’s significant debt build-up since the 2008-09 global financial crisis, policymakers will need to do more to lower lending costs and to encourage further lending as global economic growth continues to slow;
  2. Most of the debt build-up in China’s economy over the last 7 years has occurred within the country’s corporate sector–with real estate developers incurring much of the leverage. In other words, both real estate prices and investments are the most systemically important components of the Chinese economy. While real estate prices and sales in Tier 1 cities have been strong this year, those of Tier 2 and Tier 3 cities have not yet stabilized. This means policymakers will maintain an easing bias unless Chinese real estate sales and prices recover on a broader basis;
  3. Chinese credit growth in August met expectations, but demand for new loans did not. Real borrowing rates for the Chinese manufacturing sector is actually rising due to overcapacity issues and deteriorating balance sheets (China’s factory activity just hit its lowest level since March 2009). No doubt Chinese policymakers will strive to lower lending costs to the embattled manufacturing sector as the latter accounts for about one-third of the country’s GDP and employs 15% of all workers. This will be accompanied by a concerted effort to ease China’s manufacturing/industrial overcapacity issues through more infrastructure investments both domestically and in China’s neighboring countries (encouraged by loans through the Asian Infrastructure Investment Bank, for example).

I contend, however, that the PBOC is done with cutting its one-year policy rate for this year, as Chinese policymakers are dealing with a more pressing issue: stabilizing the Chinese currency, the yuan, against the US$ in the midst of recent capital outflows (Goldman Sachs estimates that China’s August capital outflows totaled $178 billion). Simply put–by definition–a country cannot prop up its currency exchange rate while easing monetary policy and maintaining a relatively open capital account at the same time. With the PBOC putting all its resources into defending the yuan while capital outflows continue, it will be self-defeating if the PBOC cuts its policy rate at the same time. The PBOC’s current lack of monetary policy flexibility is the main reason why Chinese policymakers are trying to find ways to stem capital outflows.

Rather than easing monetary policy, Chinese policymakers are utilizing other means to directly increase economic growth, such as: 1) Cutting minimum down payment requirements for first-time home buyers from 30% to 25%, 2) Approving new subway projects in Beijing, Tianjin, and Shenzhen worth a total of $73 billion over the next six years, and 3) Cutting sales taxes on automobile purchases from 10% to 5%, effective to the end of 2016. I expect the PBOC to regain its monetary policy flexibility by early next year, as the combination of record-high trade surpluses and still-low external debt should allow China to renew its policy of accumulating FOREX reserves yet again.

The U.S. Needs to Rejuvenate the Global Supercomputing Race

Technology, along with increasing access to cheap energy, is the lifeblood of a growing, modern economy. As we discussed in our December 2, 2012 article (“The Global Productivity Riddle and the Supercomputing Race“), fully 85% of productivity growth in the 20th century could be attributed to technological progress, as well as increasing accessibility/sharing of cheap energy sources due to innovations in oil and natural gas hydraulic fracturing, ultra-deep water drilling, solar panel productivity, and the commercialization of Generation III+ nuclear power plants and deployment of smart power grids.

Perhaps the most cited example where the combined effects of technological and human capital investments have had the most economic impact is the extreme decline in computing and communication costs. Moore’s Law, the ability of computer engineers to double the amount of computing power in any given space every 2 years, has been in effect since the invention of the transistor in the late 1940s. Parallel to this has been the rise of the supercomputing industry. Started by Seymour Cray at Control Data Corporation in the 1960s, the supercomputing industry has played a paramount role in advancing the sciences, most recently in computationally intensive fields such as weather forecasting, oil and gas exploration, human genome sequencing, molecular modeling, and physical simulations with the purpose of designing more aerodynamic aircrafts or better conducting materials. No doubt, breakthroughs in more efficient supercomputing technologies and processes is integral to the ongoing growth in our living standards in the 21st century.

Unfortunately, advances in both the U.S. and global supercomputing industry has lagged in the last several years. Every six months, a list of the world’s top 500 most powerful supercomputers is published. The latest list was compiled in June 2015; aside from providing the most up-to-date supercomputing statistics, the semi-annual list also publishes the historical progress of global supercomputing power, each country’s share of global supercomputing power, as well as a reasonable accurate projection of what lies ahead. Figure 1 below is a log chart summarizing the progression of the top 500 list from its inception in 1993.

Figure 1: Historical Performance of the World’s Top 500 Supercomputers

top500progressAs shown in Figure 1 above, both the sum of the world’s top 500 computing power, as well as the #1 ranked supercomputer, has remained relatively stagnant over the last several years. Just three years ago, there was serious discussion of the commercialization of an “exaflop” supercomputer (i.e. a supercomputer capable of 1 x 10^18 calculations per second) by the 2018-2019 time frame. Today, the world’s top computer scientists are targeting a more distant time frame of 2023.

From the U.S. perspective, the slowdown in the advent of the supercomputing industry is even more worrying. Not only has innovation slowed down at the global level, but the U.S. share of global supercomputing power has been declining as well. Three years ago, the U.S. housed 55% of the world’s top 500 supercomputing power; Japan was second, with 12% of the world’s supercomputing power. Rounding out the top five were China (8%), Germany (6%), and France (5%). Today, the U.S. houses only 46% of the world’s supercomputing power, with countries such as the UK, India, Korea, and Russia gaining ground.

Figure 2: Supercomputing Power Distributed by Country

top500countryshare

Bottom line: Since the invention of the transistor in the late 1940s and the advent of the supercomputing industry in the 1960s, the U.S. has always led the supercomputing industry in terms of innovation and sheer computing power. With countries such as China and India further industrializing and developing their computer science/engineering expertise (mostly with government funding), U.S. policymakers must encourage and provide more resources to stay ahead of the supercomputing race. To that end, President Obama’s most recent executive order calling for the creation of a National Strategic Computing Initiative–with the goal of building an “exascale” supercomputer–is a step in the right direction. At this point, however, whether the industry can deploy an energy-efficient exascale supercomputer by the less ambitious 2023 time frame is still an open question.

Chinese Casino Gaming Companies Up Despite Chinese Stock Market Rout

Just over two weeks ago, I was interviewed by CNBC Asia; they asked what I was advising my clients to purchase in the Chinese stock market. I specifically mentioned two Chinese companies that are traded offshore – in this case, I discussed Melco Crown (MPEL) and Las Vegas Sands (LVS). MPEL is up +10.1% while LVS is up +6.7% since the day of the June 21st interview. Meanwhile, the Shanghai Composite Index is down by 16.7% in the same time frame.

Policymakers have dealt Chinese casino gaming companies a bad hand (pun intended), e.g. limiting the number of Macau visas, full smoking ban at the casinos, and monitoring Chinese VIP customers, but in general, Chinese casino gaming companies are well-run; despite the slowdown in visitations over the last 18 months, Chinese casinos are enjoying positive cash flow in an oligopolistic market (the government has only awarded six gambling licenses and have limited the number of tables available to patrons). Both MPEL and LVS are poised to take advantage of the ongoing growth in Chinese casino gaming & entertainment spending, driven by the more profitable mass-market clientele in the future.

Leading Indicators Suggest Lower U.S. Treasury Rates

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:

OECDleadingindicators

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).

10yeartreastudy

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.

Why Crude Oil Prices Will Recover Faster than You Think

Over the last six months, WTI crude oil prices declined from a peak of $107 to $60 a barrel, or a decline of 44%. Many analysts, including the Energy Information Administration (EIA), are forecasting even lower prices, and more glaringly, for prices to stay at these levels for at least the next 12-24 months. The EIA is forecasting WTI crude oil to average $63 a barrel in 2015 (down from its October forecast of $95 a barrel), while Andy Xie, a Chinese economist, is forecasting oil prices to stay at $60 over the next five years.

The oil market is now in a state of panic. We believe WTI crude oil prices will recover to the $75 to $85 range by the second half of 2015 as: 1) fear in the oil markets subsides, 2) shale production growth plateaus or even declines, and 3) global demand increases as a reaction to lower oil prices. Let’s examine these three reasons in more detail.

1) Oil markets are panicking and prices will bounce back after the fear subsides

At $60 a barrel, WTI is now more than two standard deviations below its 200-day moving average, its most oversold level since March 30, 2009. With the exception of the 6-month declines during: 1) late 1985/early 1986, and 2) summer 2008 to December 2008, the WTI crude oil price is now at a level which has previously marked a multi-year bottom. More importantly–from a technical standpoint–oil prices have always bounced faster than most analysts expected. E.g. After hitting $10.73 a barrel in December 1998, WTI rose by 80% to $19.28 a barrel over the next 6 months; similarly, after hitting $17.48 a barrel in November 2001, WTI rose by 68% to $29.38 over the next six months. Note that in the latter case, the rise in oil prices occurred despite the 9/11 attacks and the fact that the U.S. economy was in recession. Just like today, analysts were expecting oil prices to remain low during December 1998 and November 2001. In its December 2001 forecast, the EIA expected WTI to average $21.79 a barrel in 2002. WTI would average $26.17 in 2002, or 20% higher. We believe the current supply/demand dynamics today are even more conducive for a quick snap-back and a subsequent stabilization at higher crude oil prices.

oiltradingsystem12102014

2) Shale production growth will subside faster than expected

Our recent MarketWatch.com article discusses three reasons why the U.S. shale supply response in reaction to lower oil prices will be faster than expected. Those are: i) shale drilling is inherently capital intensive; many shale E&P firms have relied on GAAP and dubious accounting practices to mask the high, ongoing costs to sustain shale production, ii) unlike the major, multi-year projects undertaken by major, integrated oil companies, shale production growth is highly responsive to prices, and iii) shale depletion rates are much faster than those of conventional oil production.

These arguments for faster-than-expected shale production declines are stronger than ever. Firstly, shale drillers have only sustained the boom as long as there was ample financing, but this game is now about to end. The spread for high-yield energy debt has already jumped from less than 450 basis points in September to 942 basis points today. We expect financing to dry up for marginal drillers and fields; higher financing costs will also increase the costs of shale oil production, creating an overall higher hurdle for shale projects. Secondly, shale fields on average take about 6-9 months to come online, which is much faster than for most conventional projects. With such a quick response time, we expect shale production growth to slow down dramatically by April-May of 2015. Thirdly, higher efficiencies have meant faster depletion rates. Shale producers are looking for quick paybacks, and so are highly incentivized to begin and ramp up production as quickly as possible. As discussed by the EIA, the monthly decline in legacy shale oil production is about 300,000 barrels a day. We expect U.S. shale oil production to begin declining by April-May of 2015 unless prices rise back to the $75-$85 a barrel range.

3) Global oil demand to surprise on the upside

Our recent MarketWatch.com article discusses why U.S. gasoline consumption is already surprising on the upside, with the AAA estimating that Thanksgiving travel by car was up by 4.3% from last year, and the highest in the number of miles driven in seven years (versus EIA’s estimate of a 20,000 barrel decline in U.S. gasoline consumption in 2015). Higher demand is also now materializing in other parts of the world. For example, the Society of Indian Automobile Manufacturers reported a higher-than-expected 10% year-over-year rise in domestic passenger vehicle sales due to lower fuel prices. We expect Indian automobile growth to pick up even more next year as the Reserve Bank India (India’s central bank) will likely cut policy rates by early next year. This will reduce the cost of auto loan financing, thus increasing automobile affordability for the Indian middle class. In addition, Chinese car sales in November still increased by 4.7% year-over-year despite an economic slowdown and a broad government mandate to limit car ownership in major cities. We believe both Chinese and Indian oil demand growth will be resilient as both the country’s central banks have ample room to slash interest rates, thus countering any pressures of a further global economic slowdown.

Now, more than ever, we reiterate our bullish stance on oil prices. We expect WTI crude oil prices to bounce back soon and to stabilize and mostly trade in the $75-$85 range by the second half of 2015.

WTI Crude Oil – Blood in the Streets

Buy when there’s blood in the streets, even if the blood is your own.” – Nathan Mayer Rothschild, 1815

As we are writing this, WTI crude oil is trading at $69 a barrel, a fresh 4-year low, after OPEC refused to cut production as a response to the recent decline in oil prices. Prior to today’s OPEC meeting, Brent option time spreads indicated a 250,000 barrel/day cut by OPEC, while as much as 42% of analysts polled by Bloomberg expected a cut; therefore, today’s 6% decline in the WTI oil price as a response to a no-cut decision is not surprising. The following chart puts into perspective the ferocious decline of oil prices over the last five months (spot WTI traded as high as $107 a barrel in June).

oiltradingsystem11272014

The green line represents the WTI spot price (left axis); while the blue line shows the percentage deviation of the daily WTI spot price from its 200-day moving average (right axis). With today’s decline to $69 a barrel, the WTI spot price is now trading at 29% below its 200-day moving average. A further drop to $65 a barrel would put the WTI spot price at 2 standard deviations below its 200-day moving average. Should it hit that level, crude oil would be trading at its most oversold level since April 2009, and prior to that, November 2001 (when the U.S. entered a recession in the aftermath of the September 11th attacks on the World Trade Center).

We reiterate our conclusion from our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). Quoting our conclusion:

With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.

At the time of our November 19, 2014 commentary–while certain E&P companies were already cutting their 2015 capex budgets–we realize panic has not set in yet in the E&P industry. We believe this will now change as WTI crude oil prices definitively decline to below $70 a barrel. Our analysis suggests that around 18% of all global oil production will not be profitable with WTI/Brent below $70 a barrel. Even pricing in a 10% cost deflation (e.g. day rates for rigs have already declined substantially), many shale oil and Canadian heavy oil producers will still not realize a profit with WTI oil at $69 a barrel. While prices would continue to be volatile over the next several months, we believe crude oil prices are now close to a bottom. More importantly, we believe many U.S. E&P firms will not only cut capital spending in 2015 (debt financing costs for new shale oil projects have already risen by 200-300 bps across the board)–but will divest assets in order to stem cash flow issues. Clients who have cash on the sidelines will be presented with an excellent, once-in-a-decade buying opportunity as distressed assets come onto the market over the next 6 months.

Here’s why–with WTI at $69 a barrel–we are now long-term bullish on oil & gas assets:

1) E&P firms will be desperate for cash and will slash production at the same time

This is the primary reason why we are bullish with WTI crude oil at $69 a barrel; and more importantly, why we believe the 1st half of next year will present a once-in-a-decade buying opportunity for distressed assets, even if we factor in a 10% cut in the cost of production of U.S. independent E&P firms. Our analysis of 29 independent E&P firms suggests a funding gap of over $13 billion with WTI crude oil at $69 a barrel based on current capex budgets. Secondly, none of the key U.S. shale oil fields are profitable with WTI crude oil at $69 a barrel and Brent at $72 a barrel, even assuming a 10% across-the-board reduction in costs of production (see below exhibit).

Exhibit: Breakeven Brent Oil Prices at Key U.S. Shale Fields Assuming Base Case Well Costs
and a 10% Reduction in Costs of Production

e&pcostofproductionWith WTI crude oil at $69 a barrel, U.S. oil producers will be cutting capex and putting distressed assets on sale at the same time. Clients will thus be able to: 1) purchase oil & gas assets at distressed prices, 2) purchase oil & gas assets going into a declining production/rising oil price scenario. Clients who are more risk-averse can also purchase equity or debt at existing E&P firms at discounted prices. We would not be surprised if U.S. oil production actually decline next year (right now, U.S. oil production is expected to increase from 9 million barrels/day today to 9.5 million barrels/day by the end of 2015).

2) U.S. oil demand will surprise on the upside

The EIA currently estimates U.S. oil consumption to rise by only 160,000 barrels/day next year, based on a scenario of relatively slow economic growth, higher vehicle fuel efficiencies, and simply less driving as more baby boomers retire. But with WTI crude oil at $69 a barrel–and with U.S. employment growth still recovering–Americans will likely spend more time on the road next year than currently expected. The argument for an upside surprise is even more compelling since Americans are still driving less miles than at the peak in 2007–which is unprecedented in the history of the automobile–as seen in the below chart.

USmilesdriven12MA

3) The ECB’s one-trillion euro quantitative easing policy will buoy demand and support commodity prices

The European Central Bank’s Vice President and second-in-command, Vitor Constancio, is now on record for advocating a one-trillion euro quantitative easing policy to begin as early as the 1st quarter of 2015. The purchase would involve all of the Euro Zone’s sovereign bonds (including those of Greece), with the allocation to be determined by the relative size of each euro member’s economy. If implemented, this will not only lower the cost of sovereign borrowing across the Euro Zone, but would also act as a transmission mechanism for other forms of borrowing by improving the health of banks’ balance sheets, while increasing the region’s inflation outlook. All else equal, this should also provide a boost to commodity, and of course, oil prices as well.

Bottom line: WTI crude oil prices at $69 a barrel will provide once-in-a-decade, distressed buying opportunities for clients over the next 6 months, as well as excellent opportunities to purchase equity or debt of independent E&P companies.

Emerging Markets’ Desperate Need for Renewables

In our October 28, 2013 commentary (“An Early 21st Century Narrative: The Age of Renewables“), we asserted that–due to increasing domestic crude oil production and the ongoing adoption of renewable fuels–U.S. energy independence on a national level is a foregone conclusion. The Energy Information Administration (EIA) chronicles that last year, as much as 84% of total U.S. energy demand was fulfilled by domestic sources, the highest level in 30 years.

Exhibit 1: U.S. Energy Production at 30-year High Relative to Consumption

domesticproduction2013

Interestingly, 10% of our domestic energy production now comes from renewables (including hydro, solar, wind, biofuels, and thermal). We believe government agencies in general are too pessimistic regarding the trajectory of the increasing impact of renewables on U.S. and Developed Markets’ energy production. For example, Germany (a country not known for its sunshine) recently generated over half of its electricity from solar for the first time, while Great Britain’s installed solar capacity doubled over the last year–none of which anyone has foreseen. Because of the rapid adoption of renewables, as well as the ongoing shale revolution, we continue to believe that U.S. energy independence on the national level is a foregone conclusion.

What we are more interested in–as investors and global citizens–are two more ambitious goals: 1) energy independence at the community or household level through microgrids and a “smart,” decentralized distribution system, and 2) bringing electricity and heating to more undeveloped areas of the world. The International Energy Agency (IEA) estimates that 1.3 billion people today are still without access to electricity, while 2.6 billion people have no access to clean cooking facilities.

This is a glaring social problem not just in Sub-Saharan Africa but in other developing countries/regions, such as India, China, and Developing Asia. e.g. The IEA contends that as much as 25% of India’s population today have no access to electricity. A country where a vast segment of its population is disenfranchised is both a significant impediment for future economic growth and social harmony.

According to the IEA’s 2014 World Energy Investment Outlook, global policy makers and corporations are projected to invest $40.2 trillion into our energy production and transportation infrastructure from now till 2035. 59% of these funds will be used to maintain current production, while 41% will be for new development. Two interesting trends are expected to continue over the next 20 years:

  1. There is a decisive trend towards investing into renewables and efficiency programs in both developed and emerging market countries;
  2. The role of public policy makers in shaping global energy policy has been on the rise, and will continue to rise for the foreseeable future as governments set goals for renewables adoption (e.g. California’s 33% renewables goal by 2020) and new efficiency standards.

Within the developed world, these two trends are driven by environmental and domestic energy security concerns. Within Emerging Markets, however, these are driven by more fundamental concerns. For example, economic growth and the rising cost of energy has led to a significant deterioration of China’s and India’s trade accounts in recent years. The rising cost of energy (combined with significant gold imports) was instrumental in causing India’s financial crisis last summer.

Exhibit 2: Oil Import Bills of Net Importing Developing Countries on the Rise (source: IEA)

oilimportbillEMSince 2011 (the IEA’s last study on Emerging Markets’ energy imports), energy dependence in countries like China and India has continued to rise. In fact, China’s oil imports are projected to rise above that of the U.S. sometime this year. As such, investments in renewables in both China and India are not only necessary due to environmental concerns, but national security concerns as well.

Finally, as discussed above, there is also a dire need to empower those who currently have no access to electricity in many developing countries, including India. This is crucial to sustain high economic/productivity growth, as well as for long-term social cohesion (having electricity inherently increases access to education, knowledge, and healthier lifestyles). The IEA estimates that an additional $641 billion in investments is needed to achieve universal access to electricity by 2030, $135 billion of which is needed in India. In light of the $40.2 trillion of projected investments in the global energy sector over the next 20 years, $641 billion is achievable. However, the IEA also stresses that much of these investments would need to be made in rural areas with little or no access to any existing infrastructures (e.g. power lines or even paved roads). Since the costs of building a centralized grid (or expanding the current grid) to rural areas are prohibitively high, the only alternative is to install microgrids or roof-top solar in such undeveloped rural areas. The age of renewables will thus not only bring U.S. energy independence, but increased energy access to the rest of the world as well.

 Exhibit 3: Additional Investment Required for Universal Access to Electricity ($billion in year 2010 dollars; source: IEA)

energyaccessforpoor