The Re-leveraging of Corporate America – Part II

We last discussed the increasing leverage in U.S. corporate balance sheets in our April 1, 2015 commentary (“The Re-leveraging of Corporate America and the U.S. Stock Market“), when we asserted that the combination of historically high U.S. stock market valuations, extremely high participation in the U.S. stock market by hedge fund managers (from a contrarian standpoint), and near-record high corporate leverage makes the U.S. stock market highly vulnerable to a major correction over the next several months.

At the time, we noted that U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. Moreover, U.S. corporate debt issuance was on track to hit a record high in 2015, buoyed by the ongoing surge in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a private equity sponsor exit), along with record share buybacks and the pressure to increase dividends. At the time, we noted that U.S. corporate debt issuance was on track to hit $1 trillion this year.

Since April 1, U.S. corporate debt issuance has continued to increase, although the pace has slowed down since concerns about the Greek debt crisis and the Chinese economic slowdown materialized this summer. Moreover–with energy and metals prices still underperforming–high-yield issuance has slowed down dramatically, although investment-grade issuance has continued to plough ahead. Nonetheless, U.S. corporate issuance has already set a record high this year, with nearly $800 billion of debt issued on a YTD basis (as of last Friday). At the current rate, U.S. corporate debt issuance could still hit $900 billion this year given the still-substantial pipeline of debt issuance driven by the recent frenzy of M&A activity.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($ billions)

uscorporatedebtissuanceNov2015

Moreover, U.S. net cash levels–that of Apple notwithstanding–have been crumbling under ever-increasing dividend yields, corporate buybacks, and M&A activity. Figure 2 below shows the substantial increase of debt/EBITDA ratios in Goldman’s universe coverage–especially since 2011–while companies with positive net cash levels are down by about one-third in the same time frame.

Figure 2: Rising Corporate Leverage While Cash Levels Continue to Decline

uscorporateleveragevscashDespite the August correction, we believe U.S. stocks remain overvalued. Combined with increasing and near-record high corporate leverage levels, this leaves U.S. stocks in a highly vulnerable position. With the Fed poised to begin a new rate hike cycle at the December 16 FOMC meeting , we believe there is a strong likelihood of a more substantial (15%-20%) correction in the S&P 500 from peak to trough sometime in 2016.

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.

Three Key Policies to a Successful “Make In India” Initiative

Launched by the Narendra Modi-led government last September, the “Make In India” initiative is a long-term, top-down driven policy to transform India into a global manufacturing hub. The 25 economic sectors targeted by the Indian government for export-led development were those determined to possess global trade comparative advantages or significant potential for innovation and job creation. Some of these sectors include: automobiles, aviation, biotechnology, chemicals, defense, electrical machinery, food processing, media & entertainment, pharmaceuticals, railways, renewable energy, and textiles & garments.

In my recent weekly newsletters–and in my March 4, 2015 Forbes column (“Modi’s Budget Boosts Bullish Outlook for Indian Stocks“)–I have chronicled and discussed the recent re-acceleration of India’s economic growth due to a combination of government reform efforts and the decline in oil prices, the latter of which provided an immediate 3%-3.5% boost to India’s annual GDP. Since August last year, I have asserted that India’s economic growth rate would surpass that of China; this year, I expect India’s GDP to grow at about 8%–higher than China’s expected GDP growth rate which I expect to come in at 7% or below.

Recent economic data–such as April’s industrial production year-over-year growth of 4.1% (surpassing consensus by more than 200 bps) and May’s benign CPI reading of 5.0%–suggests that my Indian economic outlook is on track. With the Reserve Bank of India’s policy repo rate still at 7.25%, there remains significant room for the Indian central bank to ease monetary policy in order to maintain the country’s high growth rates, as long as the CPI reading stays below 6.0%.

I maintain that India’s long-term growth trajectory remains intact; I expect the size of India’s economy to double by the end of 2020–to $4 trillion or more–and for the earnings of the MSCI India equity index to more than double in the same time frame. In the past, I have discussed several reform policies and trends that would act as secular tailwinds for the India economy, including: 1) a concerted crackdown of cronyism and corruption and raising foreign direct investment caps from 26% to 49% in the insurance and defense industries–both of which would heavily encourage more FDI inflows into India, 2) a renewed focus on infrastructure investments–including a nationwide 4G network–as well as much-needed land reforms to encourage further industrialization, 3) rising confidence in the leadership of the Reserve Bank of India as Governor Rajan asserted the central bank’s independence with an inflation-targeting framework that was recently codified into law, and 4) India’s uniquely young and educated workforce.

I consider the “Make in India” initiative to be a major policy focus that is essential to India’s long-term economic development. Unlike China’s “growth at all costs” policy from 1978 to 2008–i.e. a 19th century style command-and-control network of various centralized systems of production–while taking advantage of low-cost labor and lax environmental regulations, India is encouraging the production of higher value-added goods through a more decentralized approach of empowering decision-makers at the corporate level. At the same time, India’s labor laws have historically offered a high degree of protection for workers. To a major extent, India’s historical rejection of the 19th century style of command-and-control capitalism has limited the country’s industrialization and consequently, its export sector of manufactured goods. Of course, over the last 25 years, India’s exports have increased both as a share of GDP and world exports–but this was mostly driven by increases in the exports of services and primary products & resources (i.e. rice, cotton, diamonds, iron ore, etc. )–as opposed to the exports of medium- and high-tech manufactured goods.

Figure 1: India – Exports of Goods and Services, 1991-2013 (source: IMF)

Indiaexports

Since 1991, total Indian exports as a share of Indian GDP rose from around 8% to almost 25% in 2013; while Indian exports as a share of world exports tripled from around 0.5% to 1.7% during the same time frame. Of note, however, is the rapid increase in Indian service exports in just the recent decade. From 2000-2013, Indian services exports as a share of world services exports have tripled to over 3.0%.

Growth in Indian services exports has been rapid; indeed, it has surpassed that of other EM countries by a wide margin (see Figure 2 below). Indian services now make up 35% of all of the country’s exports, which is even higher than the average in advanced economies.

Figure 2: Growth in Services Exports – India and EM Countries, 2000-2012 (source: IMF)

EMserviceexports

The vast majority of fast-growing EM economies over the last several decades relied on industrialization and subsequent growth of manufacturing exports (both absolute and relative to total exports) to jump-start their economies. In 2013, for example, China’s manufacturing exports accounted for 90% of total exports, double the share during 1980-85. The share of Indian manufacturing exports as a share of total exports, however, has actually declined over the last 15 years, due to India’s over-reliance on growth driven by the services and primary goods & resources industries. Within the goods sector, the share of manufacturing has declined over the last decade as well (see Figure 3 below).

Figure 3: Composition of Goods Exports for Selected EM Countries, 2000-04 vs. 2007-11

indiangoodsexports

To jump-start the “Make In India” initiative to turn India into a global manufacturing hub, I believe the following three key policies need to be adopted–either at the public- or private-sector level.

  1. Build human capital and liberalize the Indian labor market: Consensus suggests that the Indian manufacturing sector faces an existential problem when it comes to labor: despite a young, educated labor force, there is a shortage of qualified labor for the sector, as those who are qualified do not want to work in manufacturing. One way to entice workers into the industry is to focus on medium-tech or high-tech goods requiring innovation in an effort to boost the technological capacity of India and to raise manufacturing wages. Labor law reforms, along with a policy to integrate manufacturers into the education ecosystem, are also necessary in order to boost the competitiveness of the Indian manufacturing sector in the global markets;
  2. Investing in export- and manufacturing-related infrastructure: IMF studies have shown that bottlenecks among the energy, mining, transportation, and storage sectors have inhibited India from taking advantage of the devaluation of the Indian rupee over the last several years. Land reforms is also part of the economic agenda, as regulations have historically prevented or limited the rise of industries in urban areas, where most skilled labor is located;
  3. Trade reforms to expand trade in the long-run: Historically, the Indian government has utilized trade policy as a tool to address short-term objectives such as limiting inflation or minimizing the volatility in commodity prices. Such incoherent policies included export taxes, minimum export prices, and ad hoc adjustments to import duties. The World Trade Organization noted that in its last review, minimum export prices for onions, sugar, and potato were changed in order to control the domestic supply of vegetables. Such policies increase uncertainty for both exporters and importers – major trade reforms are thus needed to provide a long-term boost to Indian manufacturing exports.

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.

Our Leading Indicators Still Suggest Lower Asset Prices

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:

OECDleadingindicators

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.

The Re-leveraging of Corporate America and the U.S. Stock Market

The U.S. stock market as of the end of 1Q 2015 is overvalued, overbought, and overleveraged. As we discussed in our weekly newsletters over the last couple of months, the S&P 500 is trading at its highest NTM (next 12 months) P/E and P/B ratios since early 2001, just prior to the bursting of the bubble in U.S. technology stocks. Note that today’s record P/E ratios are being accompanied by the highest corporate profit margins in modern history, which in turn are supported by ultra-low borrowing rates and a highly accommodative environment for corporate borrowing.

On the demand side for stocks, we also know that global hedge fund managers are now holding the largest amount of long positions in U.S. stocks (56% net long as of year-end 2014) since records have been kept. With the global hedge fund industry now managing $2 trillion in assets, we believe it is a mature industry–as such, we believe the positions of hedge fund managers could be utilized as a contrarian indicator. In addition, note that no major U.S. indices (e.g. Dow Industrials or the S&P 500) have experienced a 10%+ correction since Fall 2011. Coupled these with the immense leverage on U.S. corporate balance sheets–as well as the U.S. stock market–this means that U.S. stocks are now highly vulnerable to a major correction over the next several months.

According to Goldman Sachs, U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. U.S. corporate debt issuance is on track to hit a record high this year, supported by the ongoing rise in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a PE exit), and share buybacks and increasing dividends. In fact–at the current pace–U.S. corporate debt issuance will hit $1 trillion this year (see figure 1 below). Over the last 12 months, member companies in the Russell 1000 spent more on share buybacks and paying dividends than they collectively generated in free cash flow. Across Goldman’s coverage, corporate debt is up 80% since 2007, while leverage (net debt / EBITDA)–excluding the period during the financial crisis–is near a decade-high.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($billions)

uscorporatedebtissuance

We believe the combination of high valuations, extreme investors’ complacency, and near-record high corporate leverage leaves U.S. stocks in a highly vulnerable position. The situation is especially pressing considering: 1) the high likelihood for the Fed to raise rates by 25 basis points by the September 16-17 FOMC meeting, and 2) the increase in financial market volatility over the last six months.

Finally, investors should note that U.S. margin debt outstanding just hit a record high as of the end of February. Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators (including ones that may not be obvious, such as the amount of leverage utilized by hedge funds through the OTC derivatives market), as well as major peaks and troughs in the U.S. stock market. Since the last major correction in Fall 2011, U.S. margin debt outstanding has increased by 69%–from $298 billion to $505 billion–to a record high. In other words, both corporate America and the U.S. stock market have “re-leveraged.” With the Fed no longer in easing mode–coupled with extreme investors’ complacency and increasing financial market volatility–we believe U.S. stocks could easily correct by 10%+ over the next several months.

margindebt0215

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.

U.S. Inflationary Pressures Remain Muted

In our January 25, 2015 weekly newsletter (please email me for a copy), we pushed back our forecast for the first fed funds rate hike (25 basis points) to the September 16-17, 2015 FOMC meeting as long-term (both 5- and 10-year) inflationary expectations in the U.S. continued to decline after the official end of QE3 on October 29, 2014. 80% of all forecasters at the time expected a rate hike by the July 28-29 FOMC meeting. Just a few days later–in the midst of the January 27-28 FOMC meeting–a new CNBC Fed survey suggests that most analysts now expect the first fed funds rate hike to occur at the September 16-17, 2015 FOMC meeting. Our prediction for the first fed funds rate hike is now the consensus.

10yearbreakeveninflation

Surveying both the data and the U.S. economy, there still seems to be no rising inflationary pressures, despite a pick-up in U.S. housing activity (due to the recent decline in mortgage rates) and a noticeable improvement in the U.S. job market. In fact, the U.S. CPI–even outside of energy–has continued to trend down over the last several months. E.g. the 12-month change in the U.S. CPI (less food and energy) declined from 1.9% in July to 1.6% in December, while neither the 16% trimmed-mean CPI nor the Median CPI have shown any signs of rising to a level that would justify a new rate hike cycle.

The $64 trillion question is: When will the Fed impose its first rate hike, and what does this mean for global asset prices (or the U.S. dollar)? The picture becomes even murkier when one takes into account the recent strength in the U.S. dollar (since we penned our Traderplanet.com ‘Euro Parity” article on September 24, 2014, the dollar has rallied from 1.27 to 1.14 in just a little over four months). Any new Fed rate hike cycle will likely reinforce the recent strength in the U.S./euro exchange rate (note: we now expect the euro to stage a bounce against the U.S. dollar as we believe the Euro Zone economy will surprise on the upside), especially given the open-ended nature of the European Central Bank (ECB)’s sovereign QE policy.

I am going out on a limb and predicting either one of the following scenarios: 1) The Fed hikes by 25 basis points at the September 16-17 meeting, but states that future rate hikes will be data-dependent, i.e. a rate hike will not signal the beginning of a new rate hike cycle, or 2) The Fed pushes back its first rate hike to its October 27-28 meeting, if not later.

The Fed must understand that capitalism is inherently deflationary. Ever since the Paul Volcker-led Fed slayed the U.S. inflation dragon in the early 1980s, the U.S. economy has consistently experienced disinflationary pressures. This accelerated with the German re-unification and the fall of the ‘Iron Curtain’ 25 years ago, and of course, Chinese entry into the World Trade Organization in 2001. Moreover, with the exception of three short bull markets (World War I, the 1970s and 2001-2008), commodity prices (adjusted for the U.S. CPI) have been on a 150-year downtrend in the United States as U.S productivity growth triumphed over the disciples of Thomas Malthus.

Finally, academic studies have time and again proven that there are no consistent reliable leading indicators for U.S. inflation. Common factors cited by analysts–such as M2, capacity utilization, and the cost of housing–all scored poorly relative to a simple auto-regressive (i.e. momentum model). Others, such as U.S. industrial production activity and the 10-year treasury yield, scored better. Surprisingly, the data shows that the rise in food prices have historically been the best leading indicator of U.S. inflation, which we do not believe will apply going forward.

Our analysis and our recent trip to four different cities in India has convinced us of this: What China did to global manufacturing India will do to the global services industry. I.e. We believe India–over the next 5-10 years–will unleash a wave of deflationary pressures in service wages across the world as the country builds up its 4G infrastructure, and as its smartphone adoption grows from 110 million to over 500 million handsets over the next 5 years. Unlike other countries under the traditional Asian development model (where a country will leverage its low-cost labor to industrialize and export goods to developed countries, such as the U.S.), India has no language barrier and is well-versed with technology, computer programming, and providing global services already. This is a hugely deflationary force to reckon with and I believe the Fed must take this into account as U.S. service wages (finance, legal, and IT) will consequently continue to be compressed over the next 10-20 years (while tens of millions of educated Indians will join the global middle class for the first time since the 1700s).