A wor­ry­ing set of sig­nals

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Reg­u­lar read­ers will know that we keep a bat­tery of in­di­ca­tors to gauge, among other things, eco­nomic ac­tiv­ity, in­fla­tion­ary pres­sure, risk ap­petite and as­set val­u­a­tions.

Most of the time this dash­board of­fers mixed mes­sages, which is not hugely help­ful to the in­vest­ment process. Yet from time to time, the data pack points un­am­bigu­ously in a sin­gle di­rec­tion and ex­pe­ri­ence tells us that such con­flu­ences are worth watch­ing.

We are to­day at such a point, and the worry is that each in­di­ca­tor is flash­ing red.

· Growth: The three main in­dices of global growth have fallen into neg­a­tive ter­ri­tory: (i) the Q-in­di­ca­tor (a dif­fu­sion in­dex of lead­ing in­di­ca­tors), (ii) our dif­fu­sion in­dex of OECD lead­ing in­di­ca­tors, and (iii) our in­dex of eco­nom­i­cally-sen­si­tive mar­ket prices. Also the US re­ces­sion in­di­ca­tor is sit­ting right on a key thresh­old.

· In­fla­tion: Our main P-in­di­ca­tor is at a max­i­mum neg­a­tive with the dif­fu­sion in­dex of US CPI com­po­nents seem­ingly in the process of rolling-over; this puts it in neg­a­tive ter­ri­tory for the first time this year.

· Risk ap­petite: The Gavekal ve­loc­ity in­di­ca­tor is neg­a­tive which is not sur­pris­ing given weak mar­ket sen­ti­ment in re­cent weeks. What wor­ries us more is the widen­ing of in­ter­est rate spreads—at the long-end of the curve, the spread be­tween US cor­po­rate bonds rated Baa and trea­suries is at its widest since 2009; at the short-end, the TED spread is back at lev­els seen at the height of the eu­ro­zone cri­sis in 2012, while the Libor-OIS spread is at a post-2008 high. More­over, all mo­men­tum in­di­ca­tors for the main eq­uity mar­kets are at max­i­mum neg­a­tive, which has not been seen since the 2013 “ta­per tantrum”.

These weak read­ings are es­pe­cially con­cern­ing, as in re­cent years, it has been the sec­ond half of the year when both the mar­ket and growth has picked up. We see three main ex­pla­na­tions for these ill tid­ings:

1) Bot­tom­ing out: If our in­di­ca­tors are all near a max­i­mum neg­a­tive, surely the bot­tom must be in view? The con­trar­ian in us wants to be­lieve that a sen­ti­ment shift is around the cor­ner. Af­ter all, most risk-as­sets are over­sold and mar­kets would be cheered by con­fir­ma­tion that the US econ­omy re­mains on track, China is not hit­ting the wall and the ren­minbi de­val­u­a­tion was a one-off move. If this oc­curs, then a strong counter- trend rally Christ­mas.

2) Tra­di­tional in­di­ca­tors be­com­ing ir­rel­e­vant: Per­haps we should no longer pay much at­ten­tion to fun­da­men­tal in­di­ca­tors. Af­ter all, most are geared to­wards an in­dus­trial econ­omy rather than the mod­ern ser­vice sec­tor, which has be­come the main growth driver. In the US, in­dus­trial pro­duc­tion rep­re­sents less than 10% of out­put, while in China, the in­vest­ment slow­down is struc­tural in na­ture. The funny thing is that em­ploy­ment num­bers ev­ery­where seem to be com­ing in bet­ter than ex­pected. In this view of things, ei­ther ma­jor economies are ex­pe­ri­enc­ing a huge drop in la­bor pro­duc­tiv­ity, or our in­di­ca­tors need a ma­jor re­fresh.

3) Cen­tral banks out of am­mu­ni­tion: The most wor­ry­ing ex­pla­na­tion for the si­mul­ta­ne­ous de­cline in our in­di­ca­tors is that air is gush­ing out of the mon­e­tary bal­loon. Af­ter more than six years of near zero in­ter­est rates, as­set prices have seen huge rises, but in­vest­ment in pro­duc­tive as­sets re­mains scarce. In­stead, lever­age has run up across the globe. Ac­cord­ing to the Bank for In­ter­na­tional Set­tle­ments’ re­cently re­leased quar­terly re­view, de­vel­oped economies have seen to­tal debt (state and pri­vate) rise to 265% of GDP, com­pared to 229% in 2007. In emerg­ing economies, that






for ra­tio is 167% of GDP, com­pared to 117% in 2007 (over the pe­riod China’s debt has risen from 153 to 235% of GDP). The prob­lem with such big debt piles is that it is hard to raise in­ter­est rates with­out de­rail­ing growth. Per­haps it is not sur­pris­ing that in re­cent weeks the Fed­eral Re­serve has backed away from hik­ing rates, the Euro­pean Cen­tral Bank has recom­mit­ted it­self to eas­ing and cen­tral banks in both Nor­way and Tai­wan made sur­prise rate cuts. But if rates can­not be raised af­ter six-years of ris­ing as­set prices and nor­mal­iz­ing growth, when is a good time?

And if cen­tral banks are pre­vented from reload­ing their am­mu­ni­tion, what will they de­ploy the next time the world econ­omy hits the skids?

Hence we have two be­nign in­ter­pre­ta­tions and one de­press­ing one. Be­ing op­ti­mists at heart, we want to be­lieve that a com­bi­na­tion of the first two op­tions will play out. If so, then in­vestors should be po­si­tioned for a counter-trend rally, at least in the short­term. Yet we are un­set­tled by the mar­ket’s muted re­sponse to the Fed’s dovish mes­sage. That would in­di­cate that in­vestors are lean­ing to­wards the third op­tion. Hence, we pre­fer to stay pro­tected and for now are not mak­ing a bold grab for fall­ing knifes. At the very least, we seek more con­fir­ma­tion on the di­rec­tion of travel.

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