EU-Wide Stress Test Results Adding to Systemic Risk

As professional investors, we have been trained by the markets, the CFA Institute, and business school professors early on to avoid certain kinds of investments. Examples include scams such as Florida swampland (if it is too good to be true, it usually is) and obsolete businesses such as U.S. textile mills (by far Warren Buffett’s worst investment in his storied career) or newspapers & magazines whose revenues are still dependent on print advertising.

As I previously pointed out, Italian banks, along with systemically-important Deutsche Bank, have the distinction of fitting into both categories. Deutsche Bank’s core investment banking & trading businesses are obsolete in the post-crisis, capital-constrained world (think Basel III, Basel IV, Solvency II, and IFRS9), and yet Deutsche’s leadership remains in denial. Meanwhile–as I pointed out in two earlier blog posts (“Strengthening the Global Banking System’s Weakest Link” published on April 12, 2016 & “Italy’s NPLs Still the Global Banking System’s Weakest Link” published on July 7, 2016)–Italian policymakers have for years refused to reform or even acknowledge the growing NPL problem within the Italian banking system. It wasn’t until this year that investors finally forced Italian policymakers and banks to act; more than 7 months into the year, they have yet to provide a stronger or more comprehensive solution that will likely involve a combination of (hugely dilutive) capital raises, offloading NPLs to foreign investors, along with some kind of “bail-in” steps for the Italian bank with the worst balance sheet, i.e. Banca Monte dei Paschi di Seana (BMPS).

The publication of the 2016 EU-Wide Stress Test last Friday was intended to alleviate solvency concerns and to halt the vicious cycle of declining European bank stock prices that began early this year. 51 large European banks holding 70% of all European banking assets were covered. These banks were domiciled in the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Netherlands, Norway, Poland, Spain, Sweden, and the UK. Banks in two of the Euro Zone’s most troubled economies, i.e. Greece and Portugal, were not included in the stress test.

Key macroeconomic assumptions/projections of the 2016 stress test (see Figure 1 below) were similar in severity relative to those in the 2014 stress test. E.g. the 2014 stress test assesses a 3-year cumulative real GDP “shock” of -7.0% in the Euro Area, vs. a 3-year cumulative -7.1% shock in the 2016 stress test, as shown in Figure 1 below.

Figure 1: Key Macroeconomic Assumptions/Projections of the 2016 EBA Stress Test
eba2016stresstestassumptions

The 2016 stress test, however, did refine its overall framework by adding two explicit assumptions relative to the 2014 stress test: 1) explicit bottom-up treatment of FX-related trading losses to entities in central and eastern Europe in the event of EM currency depreciation, and 2) cumulative losses of 71 billion euros driven by the concept of “conduct risk,” with 15 of the 51 banks tested having a conduct risk liability of more than one billion euros.

On the surface, the results of the 2016 stress test were relatively benign. The 51 banks in the sample had a weighted average fully loaded CET1 capital ratio of 12.6% as of year-end 2015. This starting point was 150 bps above that for the 2014 and 400 bps over that for the 2011 stress test. Since December 2013, the fully loaded CET1 capital for the 51 banks sampled has increased by 180 billion euros. Under the “adverse scenario,” the 2016 stress test estimates a decline of 340 bps in the weighted average CET1 ratio to 9.2% by the end of 2018, driven mostly by projected credit losses, conduct losses, and losses stemming from counter-party risks. More importantly–out of the 51 banks sampled–only 10 banks finished with a fully loaded CET1 capital ratio of less than 8.0% by year-end 2018 (post any mitigation measures enacted after year-end 2015). They are: BMPS (-2.44%), Allied Irish Banks (4.31%), Raiffeise-Landesbanken-Holding (6.12%), Bank of Ireland (6.15%), UniCredit (7.10%), Barclays (7.30%), Commerzbank (7.42%), SocGen (7.50%), Deutsche Bank (7.80%), and Criteria Caixa (7.81%). Figure 2 below shows the EBA’s projected fully loaded CET1 capital ratios as of year-end 2018 on a bank-by-bank basis:

Figure 2: Fully Loaded CET1 Ratios at Year-End 2018 Under the EBA’s Adverse Scenario
(source: Goldman Sachs, EBA)
CET1 Ratios

Unfortunately, as I have asserted in my weekly global macro newsletters and my last two blog entries on the Italian banking system, what investors are looking for is not a “rubber stamp” approval by bank regulators on the integrity of European banks’ balance sheets or a halfhearted fund-raising effort by BMPS, but a strong, decisive, and system-wide capital-raising effort with government backing, along with a multi-year reform plan to rebuild the sustainability of long-term profits currently being impeded by: 1) prevalence of negative interest rates across much of the Euro-wide yield curve, 2) slow structural growth rates, especially within countries such as Italy, Portugal, and Greece, and 3) obsolete business models where certain business operations (e.g. trading) are being quickly replaced by hedge funds and fintech companies.

Over the last two trading days, European banks’ stock prices (ETF ticker EUFN) have fallen by nearly 3%. In particular, BMPS is down by 13%, UniCredit by 15%, Barclays by 5%, and Deutsche Bank by 7%. Major criticisms of the framework/results of the EBA’s 2016 stress test have been as follows:

  1. Banks in the region’s two most NPL-challenged countries, Greece and Portugal, were not included in the stress test;
  2. Under the BMPS rescue plan conceived last Friday, the bank will securitize its entire bad loan portfolio (face value of 27.7 billion euros) at a price of 33 cents on the euro. A securitization at this price is below investors’ expectations; this means if other Italian banks are forced to take similar haircuts on their NPLs, their capital ratio position would be less than what the 2016 stress test currently implies, thus requiring a more substantial (and dilutive) capital raise on the part of Italian banks;
  3. The stress test did not include the impact of regulations that are likely to be implemented over the next several years. Known collectively as “Basel 4,” KPMG estimates that these would lead to an extra 350 billion euros of capital requirements for the world’s largest 100 banks.

Bottom line: The publication of the EBA’s 2016 stress test results have failed to quell investors’ concerns of a systemic meltdown of the Italian banking system. Moreover, a successful recapitalization of BMPS is far from assured, as its capital raise is contingent on the sale of its 27.7 billion euro NPL portfolio, the latter of which will likely result in a larger-than-expected haircut on the Italian-wide 360 billion euros of NPLs. Continue to underweight European financials, especially Deutsche Bank and Italian banks in general.

Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization 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 upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. 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 some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

Strengthening the Global Banking System’s Weakest Link

As I discussed in my most recent newsletter (please email me to request a copy) and in my February 19, 2016 Forbes column (“Shares Of Global Banks Are Too Cheap To Ignore“), I remain constructive on shares of U.S. financial companies, despite (or even because of) their recent underperformance. More specifically, I asserted that much of the current fears (e.g. impact of rising energy-related defaults and ongoing litigation costs & financial penalties related to conduct leading up to the 2008-09 global financial crisis) surrounding U.S. and global financial stocks are overblown.

I also asserted that share prices of global financial companies in 2016 will mostly be driven by the Federal Reserve’s monetary policy, as a significant portion of U.S. banks’ revenues is driven by “net interest income,” i.e. the traditional role of banks’ borrowing short and lending long. In Wells Fargo’s case, net interest income makes up more than 50% of the firm’s revenue. If the Fed embarks on a renewed hiking campaign and the U.S. yield curve flattens, then U.S. banks’ margins will be hit, which in turn will depress their share prices.

Fortunately, the U.S. yield curve is still very far away from flattening. E.g. As of this writing, the spread between the 10- and the 1-year Treasury rate stands at 1.27%. Just as important, the CME Fed Watch indicator does not suggest a rate hike until the FOMC’s December 21, 2016 meeting at the earliest. Moreover–despite the recent underperformance of U.S./global financial stocks–credit risk for the global financial sector remains relatively and historically low; in fact, as computed by S&P Global Market Intelligence, the implied credit risk within the global financial sector is actually the lowest out of all ten major S&P global sectors.

As financial history and the experience of the 2008-09 global financial crisis have demonstrated, however, the global financial system is only as strong as its weakest links; and it is these “weakest links” that investors have recently focused on. More specifically, the slow pace of general and banking reforms within the Euro Zone, particularly the relatively high level of nonperforming loans in the Italian banking sector, is raising the specter of counter-party risks and resulting in a flight of capital away from Italian/European financial stocks (e.g. UniCredit is down 37% YTD, Intesa down 26%, and Banco Popolare down 38%), and to a lesser extent, U.S. financial stocks.

Figure 1: Italian Banks Have Relatively High NPL Ratios (as of June 2015)

europenpls

The Italian banking system is saddled with about 360 billion euros of NPLs, making up about one-third of the Euro Zone’s total NPLs (although 50% of it has already been provisioned). With Italian banking stocks down nearly 20% YTD (and down 25% over the last 12 months), Italian policymakers are now being forced to act to shore up the country’s bank balance sheets through sales of NPLs, equity raises, and accelerating the write-off of NPLs. An effort in January to encourage sales of NPLs by providing government-backed guarantees gained little traction (and unfortunately attracted investors’ attention to Italian banks’ NPL problem), as Italian policymakers could not agree on how the plan would be implemented, especially in light of European rules that explicitly ban state aid to failing companies.

So far this week, Italian policymakers–working in conjunction with banks, pension funds, and insurers–have drawn up plans for a 5 billion euro bailout fund (dubbed “Atlante”) to purchase NPLs and/or to inject capital into ailing banks. Investors’ initial responses have ranged from skeptical to condescending, given the relatively small size of the fund and the lack of details surrounding its implementation. Bottom line: Italian/European policymakers, in conjunction with the private sector, will need to work harder to create a more comprehensive and workable solution to reduce NPLs in the Italian banking system. Until this happens, the current rally in U.S./global financial stocks from their early February lows will remain precarious.

Leading Indicators Suggest a Stabilization in Global Risk Asset Prices

Even as the vast majority of analysts stayed bullish on the global economy and global risk assets early last year, I began to turn bearish for a variety of reasons, including: 1) global liquidity, as measured by the amount of US$ circulating freely in the global financial system, continued to weaken, 2) valuations in U.S. equities were at the 95th percentile of all readings dating back to the late 1970s, as measured on a P/B and P/E basis, 3) U.S. corporate profit margins were already at 50-year highs, while U.S. corporate profits as a percentage of U.S. GDP was at a high not seen since 1929, 4) U.S. corporate earnings growth, ex. energy, were beginning to decelerate, and 5) our proprietary leading indicator, the CB Capital Global Diffusion Index (“CBGDI”) was indicating a global economic slowdown, as well as a pullback in global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s latest readings in many of our weekly newsletters, and last discussed it in this blog on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“). Specifically, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has also 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%, 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).

In my May 15, 2015 blog entry, I also stated:

Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year [i.e. 2014]; more importantly, the negative momentum has not abated much … 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.”

The rest is history, as they say.

Recent readings of the CBGDI, however, paint a much brighter picture. Firstly, both the 1st and 2nd derivatives of the CBGDI have stabilized and are now increasing. Secondly, both global equity prices (i.e. the MSCI All-Country World Index) and oil prices have declined to levels that are indicative of a more severe slowdown than the CBGDI readings imply (see Figure 1 below). To me, the latest readings of the CBGDI suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

CBGDIDecember2015

 

 

Margin Debt Outstanding Remains High but Suggests an Oversold Market

A client said: “U.S. margin debt outstanding remains at a very high level; as such, I expect U.S. stocks to correct further.”

We last discussed the overbought condition in U.S. stocks as measured by U.S. margin debt outstanding in our January 29, 2014 blog entry (“Record Rise in Margin Debt Outstanding = Single-Digit Stock Returns in 2014“). U.S. margin debt outstanding stood at $478.5 billion at the time (measured as of December 31, 2013), after rising by $123 billion over the previous 12 months. The rapid rate of margin debt growth at the time suggests a highly overbought market. For comparison, the 12-month increase in margin debt outstanding leading to the March 2000 peak was $134 billion; for July 2007, an unprecedented $160 billion. At the time, we stated that this rapid accumulation of margin debt would lead to tepid stock returns going forward. The S&P 500 stood at 1,848.56 as of December 31, 2013; as I am typing this, the S&P 500 is trading at just shy of 1,900. After two years, the S&P 500 has gone nowhere; although your portfolio would’ve performed well if you had an overweight in consumer discretionary and tech; less so if you had an overweight in energy or materials.

As of December 31, 2015, U.S. margin debt outstanding stood at $503.4 billion–a tepid $25 billion increase over a period of two years. With the recent sell-off in U.S. stocks, margin debt would likely have declined by at least $20 billion this month. This means U.S. margin debt outstanding as it stands today is likely to have revert to its December 31, 2013 levels. Figure 1 below shows the 3-, 6-, and 12-month absolute change (in $ billions) in U.S. margin debt outstanding from January 1998 to December 2015.

usmargindebt12312015

A margin debt outstanding of around $480 billion is still high by historical standards; however–based on the 3-, 6-, and 12-month rate of change–U.S. margin debt outstanding is actually at an oversold level–reminiscent of similarly oversold levels in late 1998, early 2008, and the 2nd half of 2011. In two of these instances (late 1998 and the 2nd half of 2011), the S&P 500’s subsequent returns were phenomenal (38% and 27%, respectively, over the next 12 months); in the case of early 2008, however, not so much. With that said, March 2008 still represented a tradeable bottom–as long as one got out of U.S. stocks by summer of 2008.

As I discussed with my clients, I do not believe the current liquidation in energy, materials, and EM assets will morph into a globally systemic event. As such, I believe U.S. stock returns will be decent over the next 6-12 months.

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.