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.

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

 

 

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.