Global Policy Divergence Still At Play

Events and economic data over the past couple of weeks reinforce the divergence between U.S. and Eurozone monetary policy.

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In terms of the ECB, the rollover of long-term inflation expectations is undoubtedly quite uncomfortable. The last thing the central bank needs is another deflation shock. Lower inflation expectations would push up real short-term interest rates, threatening to tip the Eurozone economy into a Japan-style liquidity trap.

Moreover, upward momentum in credit growth is losing steam, suggesting that growth disappointments will arrive this autumn in Europe. The combination of depressed inflation expectations and slowing growth momentum would send Bund yields sharply lower as investors discount “QE-forever” from the ECB.

In sharp contrast, the FOMC appears determined to hike rates this year. Whether one agrees with the FOMC or not, policymakers are anxious to lift rates off of the zero bound, now that the labor market is in the vicinity of full employment.

The market is still pricing in about a 50% chance of a September rate hike, implying that the short-end of the Treasury curve remains at risk.

Bottom Line: The “policy divergence” theme is still in play; favor Bunds to Gilts and Treasurys.

U.S. Equities: Disinflationary Headwinds

Stocks continue to run into a brick wall at the upper band of this year’s trading range. The best case scenario may be an extension of the recent lateral move as deflation pressures are absorbed.

Producer prices and the momentum in forward earnings estimates are tightly linked and the current message is grim (please see the chart below).

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So far, the Fed’s desire to move away from the zero bound appears to be trumping the need for immediate confirmation that inflation will track back up toward their target over the medium term.

There is still a dearth of evidence pointing to a reacceleration in global economic growth, despite easy policies abroad. The deflationary weight of deleveraging in Europe and China’s moribund economy are offsetting policymaker’s efforts to stimulate growth.

Although global trade has expanded at roughly twice the rate of world GDP for several decades, the value of exported goods has plunged, warning that corporate sector sales will deteriorate further.

We continue to recommend a capital preservation mindset and expect our defensive portfolio strategy to continue to outperform.