The Fed Paves the Way for Running a “High-Pressure Economy” (Along with Higher Inflation)

Since the beginning of last year (see my February 4, 2015 commentary “U.S. Inflationary Pressures Remain Muted” and my March 1, 2016 Forbes commentary “Why Federal Reserve Tightening Is Still A Distant Event“), I have consistently asserted that the Fed’s ultimate tightening schedule would be slower than expected–from both the perspective of the Fed’s original intentions, as well as those of the fed funds futures market. Indeed, the most consistent theme since the beginning of the 2008-09 global financial crisis has been this: The tepid recovery in global financial conditions and global economic growth has consistently forced the Fed to ease more than expected; and since the “tapering” of the Fed’s quantitative easing policy at the end of 2013, to tighten less than expected. E.g. the October 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by late 2010. Subsequent forecasts were similarly early.

According to the CME Fed Watch, the probability of a 25 bps Fed rate hike on December 14 is now over 70%. I expect the December 14 hike to occur as the Fed has been prepping the market for one 25 bps hike for months; however–similar to what I asserted last year–I do not believe this rate hike will signal the beginning of a new rate hike cycle. Rather, the timing of the Fed’s third rate hike will again be data-dependent (more on that below). Fed funds futures currently peg the Fed’s third rate hike to not occur until more than a year from now, i,e. at the December 13, 2017 FOMC meeting. This is the most likely timing for the third rate hike, for the following reasons:

1. U.S. households remain in “deleveraging” mode. Haunted by the 2008-09 global financial crisis, record amounts of student loans outstanding (currently at $1.3 trillion), and a shorter runway to retirement age and lower income prospects, U.S. consumer spending growth since the bottom of the 2008-09 global financial crisis has been relatively tepid (see Figure 1 below), despite ongoing improvements in the U.S. labor market;

Fig1PCE.png

2. The developed world & China are still mired by deflationary pressures. While the Fed had not been shy about hiking rates ahead of other central banks in previous tightening cycles, the fact that all of the world’s major central banks–with the exception of the Fed–are still in major easing cycles means the Fed has no choice but to halt after its December 14, 2016 hike. Even the Bank of England–which was expected to be the first major central bank to hike rates–was forced to reverse its stance and renew its quantitative easing policy as UK policymakers succumbs to the rise of populism. In a world still mired by deflationary pressures, the U.S. could easily succumb to another deflationary cycle if the Fed prematurely adopts a hawkish stance;

3. The Fed is no longer in denial and finally recognizes the uniqueness of the 2008-09 deleveraging cycle that is still with us today. In a June 3, 2016 speech (titled “Reflections on the Current Monetary Policy Environment“), Chicago Fed President Charles Evans asserted why this isn’t a normal recovery cycle and because of that, argued why the Fed should foster a “high-pressure” economy (characterized by a tight labor market and sustained inflation above 2%) in order to ward off downside risks in both economic growth and inflation. Quoting President Evans: “I view risk-management issues to be of great importance today. As I noted earlier, I still see the risks as weighted to the downside for both my growth and inflation outlooks … So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand … One can advance risk-management arguments further and come up with a reasonable case for holding off increasing the funds rate for much longer, namely, until core inflation actually gets to 2 percent on a sustainable basis.

President Evans’ speech was followed by similar dovish sentiment expressed by Fed Governor Daniel Tarullo in a September 9, 2016 CNBC interview, Fed Governor Lael Brainard in a September 12, 2016 speech at the Chicago Council on Global Affairs, as well as the September 2016 FOMC minutes. Finally, Fed Chair Janet Yellen explored the potential benefits of running a “high-pressure economy” after a deep recession in her October 14, 2016 speech at a recent conference sponsored by the Boston Fed. Quoting Chair Yellen:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

Bottom line: The Fed continues to back off from committing to an official tightening schedule. After the December 14, 2016 rate hike, probability suggests the next rate hike to not occur until the December 13, 2017 FOMC meeting. Until the year-over-year PCE core rate rises to and maintains a rate of 2.0% or over, the Fed will not recommit to a new rate hike cycle. This also paves the way for higher U.S. inflation; as such, clients should continue to underweight U.S. long-duration Treasuries and overweight gold.

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.

Italy’s NPLs Still the Global Banking System’s Weakest Link

I last discussed the vulnerabilities in the Italian banking system in our April 12, 2016 blog post (“Strengthening the Global Banking System’s Weakest Link“), where I asserted that–given its global inter-connectivity  today–the world’s financial system can only be as strong as its weakest link. Typically, a liquidity or solvency issue can linger on indefinitely, simply due to the absence of external shocks or because the overall global economy is doing well. In the case of the current NPL issues with the Italian banking system, an effort in January to encourage sales of NPLs by providing government-backed guarantees unfortunately attracted investors’ attention to Italian banks’ NPL issues. When we last covered this issue three months ago, Italian banking stocks were “only” down 20% YTD; today, they are collectively down by 55% YTD.

The vulnerability of the Italian banking system–and by extension, that of the Western European banking system–has come under increased scrutiny over the last several months, exacerbated by: 1) the unexpected, ongoing deflationary malaise in much of the developed world; the May 2016 Italian inflation reading was -0.3% year-over-year, worse than market expectations of -0.2%. June 2016 Italian inflation is expected to hit -0.4% year-over-year, resulting in six straight months of deflationary readings, 2) the dramatic flattening and downshift of the Western European yield curve; globally, nearly US$12 trillion of government bonds now have negative yields, and 3) an unexpected vote for “Brexit,” equivalent to a negative growth shock within the EU, as well as heightened political and economic uncertainty.

The Italian banking system in particular is saddled with 360 billion euros of NPLs, equivalent to about one-third of all of the Euro Zone’s NPLs. Moreover–as efforts since January have demonstrated–a concerted sales effort in NPLs in Europe is not a simple task. Firstly, EU rules explicitly ban the use of government-backed guarantees to cushion NPL losses. Secondly, the average restructuring period for Italian bad loans is an abnormally long 8 years; a quarter of cases take 12 years. Finally, the European market for NPLs is small and underdeveloped relative to the overall stock of NPLs in the banking system. In other words, the market for selling Italian NPLs is relatively small, and is almost non-existent without government-backed guarantees (e.g. A proposal by Apollo to purchase 3.5 billion euros of NPLs held by Italian bank Carige back in March made no progress). Italy’s NPL issues are especially concerning given the lack of core profitability of the Italian banking system (see Figure 1 below).

Figure 1: Return on Regulatory Capital of European Banks by Country – June 2015 (source: EBA, Goldman Sachs)

returnoncapitalEBA

It is generally agreed upon that an Italian government-led recapitalization of 40 billion euros into some of Italy’s largest banks (Unicredit, BMPS, and Intesa, for example) would be adequate to resolve the Italian NPL issue, as long as Euro area growth re-accelerates; at the very least, the immediate probability of a Euro-wide banking contagion would be reduced by an order of magnitude. There are two real obstacles to this “happy scenario,” however: 1) the EU, backed by Germany, is resistant to any Italian government-led efforts to recapitalize the banks at no cost to Italian bank debt holders, as this directly goes against EU rules. Any attempt to “bail-in” Italian banks would increase contagion risks among all of EU banks as both depositors and debt holders will likely take their capital and flee to either the U.S. or other safe haven asset classes, such as gold, and 2) Italian Prime Minster Matteo Renzi has promised to resign if he loses the constitutional referendum to be held in October. Recent opinion polls suggest Renzi’s campaign will fall short; this will likely lead to significant Italian and EU-wide instability given the surge of the populist Five Star Movement in recent opinion polls. Seen in this light, the fragility of the Italian banking system is an ongoing cause for concern.

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.

U.S. Consumer Spending Yet to Overheat: Fed to Pause

According to the CME Fed Watch, the chance of a Fed rate hike this Wednesday is virtually zero. The reasons for the Fed to “stand pat” have been well recited but here they are again: 1) ongoing, elevated global systemic/slowdown risks due to the recent decline in global financial stocks, a Chinese economic slowdown, and chronically low oil prices resulting in fears of higher corporate defaults, 2) despite a recent pick-up in the U.S. core inflation rate (the 12-month change in the January core CPI is at 2.2%), the Fed’s preferred measure of core inflation, i.e. the 12-month change in the core PCE, remains tolerable at 1.7%, and 3) Since the late 1990s, the world’s developed economies have mostly grappled (unsuccessfully) with the specter of deflation; e.g. over the last 3 years, the Bank of Japan expanded its monetary base by 173%, and yet, the country is still struggling to achieve its target inflation rate of 2% (Japan’s January core CPI was flat year-over-year). As such, the Fed should err on the side of caution and back off from its recent rate hike campaign.

As of today, the CME Fed Watch is suggesting 50/50 odds of a 25 basis point rate hike at the Fed’s June 15 meeting. Historically, the Fed has only hiked when the odds rise to more than 60/40, and I believe this is the case here. Many things could change from now to June 15; however, given: 1) lingering fears over a Chinese slowdown and the loss of Chinese FOREX reserves, and 2) the fact that core PCE readings have not yet registered a +2.0% reading (I need the year-over-year change in the core PCE to sustain a level of over +2.0% for many months before I am convinced that inflation is a problem), I remain of the opinion that the next rate hike will mostly likely occur at the FOMC’s September 21 meeting.

Finally–despite an ongoing rise in U.S. employment levels (see Figure 1 below)–both U.S. wage growth (see Figure 2 below) and consumer spending growth (See Figure 3 below) remain anemic. Note that both U.S. wage growth and consumer spending growth do not “turn on a dime”; this means that–until or unless we witness a sustained rise in both U.S. wage and consumer spending growth–the Fed should err on the side of caution and back off on its rate hike campaign. At the earliest, this will mean a 25 basis point hike at the FOMC’s September 21 meeting.

USemployment

Figure 2: Nominal Wage Growth Remains Below Target Despite Year-end 2015 Push

 

nominalwagegrowth

PCEgrowth

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

 

 

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.

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.

The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015

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.

To recap, we have constructed a “Global Diffusion Index” by aggregating and equal-weighting (on a 3-month moving average basis) the leading indicators data for 30 major countries in the Organisation for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia. Termed the CBGDI, this indicator has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by about three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally, as stock prices actually make up one component of the OECD leading indicators).

Our logic rests on the fact that the vast majority of global economic growth in the 20th century was only possible because of an exponential increase in energy consumption and sources of supply. Since 1980, real global GDP has increased by approximately 180%; with global energy consumption almost doubling from 300 quadrillion Btu to 550 quadrillion Btu today. That is–for all the talk about energy efficiencies–the majority of our economic growth was predicated on the discovery and harnessing of new sources of energy (e.g. oil & gas shale fracking). Until we commercialize alternative, and cheaper sources of energy, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that–despite the ongoing increase in U.S. oil production–a rising global economy will lead to higher crude oil prices.

This is what the CBGDI is still showing today, i.e. WTI crude oil prices should rise from the current $74 spot as the CBGDI still suggests significant global economic growth in 2015. 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 March 1990 to November 2014. All four indicators are smoothed on a three-month moving average basis:

CBGDI September 2014As noted, the rate of change (2nd derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been: 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues and Chinese demand came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented many producers from hedging their production.

The second derivative of the CBGDI bottomed at the end of 2011, and is still very much in positive territory, implying strong global oil demand growth in 2015. Most recently, of course, the WTI crude oil prices have diverged from the CBGDI, and are now down 20% on a year-over-year basis. While we recognize there are still short-term headwinds (e.g. U.S. domestic oil production is still projected to rise from 9 million barrels/day today to 9.5 million barrels/day next year), we believe the current price decline is overblown. We project WTI crude oil prices to average $80 a barrel next year. In addition to our latest CBGDI readings, we believe the following will also affect WTI crude oil prices in 2015:

  1. An imminent, 1-trillion euro, quantitative easing policy by the ECB: The ECB has no choice. With the euro still arguably overvalued (especially against the US$ and the Japanese yen), many countries in the Euro Zone remain uncompetitive, including France. On a more immediate basis, inflation in the Euro Zone has continued to undershoot the ECB’s target. A quantitative easing policy by the ECB that involves purchasing sovereign and corporate bonds will lower funding costs for 330 million Europeans and generate more end-user demand ranging from heaving machinery to consumer goods. While such a policy will strengthen the value of the U.S. dollar, we believe the resultant increase in oil demand will drive up oil prices on a net basis.
  2. The growth in shale oil drilling by the independent producers are inherently unpredictable. Over the last several years, the U.S. EIA has consistently underestimated the growth in oil production from fracking. With WTI crude oil prices having declined by nearly 30% over the last four months, we would be surprised if there is no significant cutback in shale oil drilling next year. Again, the EIA has consistently underestimated production growth on the upside, so we would not be surprised if the agency overestimates production growth (or lack thereof) on the downside as well.
  3. Consensus suggests that OPEC will refrain from cutting production at the November 27 meeting in Vienna. With U.S. shale oil drilling activity still near record highs (the current oil rig count at 1,578 is only 31 rigs away from the all-time high set last month), any meaningful production cut (500,000 barrels/day or higher) by OPEC will only encourage more U.S. shale oil drilling activity. More importantly, Saudi Arabia has tried this before in the early 1980s (when it cut its production from 10 million barrels/day in 1980 to just 2.5 million barrels/day in 1985 in order to prop up prices), ultimately failing when other OPEC members did not follow suit, while encouraging the growth in North Sea oil production. Moreover, OPEC countries such as Venezuela and Iran cannot cut any production as their budgets are based on oil prices at $120 and $140 a barrel, respectively. As a result, it is highly unlikely that OPEC will implement any meaningful policy change at the November 27 meeting.

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.