A short-term testing phase is underway in the global equity market, and a number of factors argue that it needs more time to play out. Five major concerns could weigh on stocks from a tactical perspective.
First, policy divergences between the Fed and the ECB are unlikely to widen further, as the ECB signaled at its March meeting that the Eurozone is past peak monetary policy easing with the latest 4-year TLTRO II bank take up coming in at €233bn fixed at 0%. Historically, the relative sovereign spread has been a reliable equity market topping out signal. The chart shows that the U.S./Eurozone 10-year sovereign bond spread has been an excellent leading indicator of the broad equity market, and the current message is to expect at least a tactical pullback. In fact, every time the spread has hit 100 basis points, relative bond market mean reversion has subsequently occurred, leading also to a broad equity market wobble.
We doubt that monetary policies can diverge significantly for much longer without any negative global ramifications. Given that the inflation expectation gap between the U.S. and the Eurozone has remained intact since last summer, real interest rate differentials are the driving factor of the recent steep divergence. Historically, this pushes capital flows onto U.S. shores to the point where the dollar typically overshoots thus draining global liquidity and eventually a tipping point occurs.
The weak link this time could be emerging markets, as a sustained and unchecked dollar bull market (underpinned by policy divergence) risks uncovering the hard currency debt excesses in the region. This is a risk we are closely monitoring.
Second, our global equity market EPS model has…