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

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.

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).

Why Commodities Will Rally Hard Over the Next 2-3 Weeks

The commodities complex is hugely oversold. US$ bullishness has not been this high since the depths of the financial crisis in early 2009. With the SNB eliminating the synthetic peg to the Euro–Euro bullishness will be revived over the next couple of weeks, as the 41% intraday decline of the Euro against the Swiss franc likely resulted in the short-term capitulation of all remaining Euro bulls. My sense is that the Euro will actually rise if the ECB chooses to adopt QE on January 22nd, as QE would mean the ECB will unconditionally try to keep the European Monetary Union together, which will be bullish for euro-denominated assets, as well as for assets leveraged to the global economy, such as commodities.

We also believe the latest 25 basis point easing by the Reserve Bank of India will be first of many rate cuts this year; China will also follow. With India now the world’s third largest oil importer, any economic acceleration in India will also be felt in the commodities complex.

As such, I believe the commodities space (oil, copper, silver, etc.) will rally hard over the next 2-3 weeks at the very least.