Global Investment Strategy

GIS May 23 (Disinflationary Growth)

Date: 2016-05-22 - Prepared by: The GISI

Between early May and September 2013, U.S. and U.K. 10-Y government bond yields nearly doubled, from around 1.6% to 3%. German 10-Y Bund yields spiked from 1.2% to 2.0%. The entire increase was driven by real yields, as inflation expectations remained essentially unchanged.

Despite these brutal moves of May-Sep 2013, the S&P 500 bull run remained intact; the S&P 500 rose by around 12% in 2012, by 25% in 2013, by 13% in 2014, and has been flat since January 2015. During the same May to September 2013 “Taper Tantrum” fiasco, WTI oil price rose from $95 to $105 but the MSCI Emerging Markets stock index collapsed by more than 15%.

The main reason behind the May-Sep 2013 spike in global bond yields was the expected increase in global growth, while the EM selloff was a typical reaction given all the previous EM selloffs during Fed tightening cycles.

When global growth expectations proved false, WTI oil collapsed by 50% within 6 months and 10Y Treasury yields halved (from 3% to 1.6%) between Dec 2013 and Dec 2014, although this time the fall in yields was driven by lower inflation expectations as well as lower real yields.

Fast forward to today. US 10-Y real bond yields (TIPS) are hovering around 0.25%, 10-Y inflation expectations are around 1.6%, the Fed is very careful to avoid another “Taper Tantrum”, M1 nominal money supply is expanding at a stable 6%, the fiscal policy is no longer a major drag on growth and the unemployment rate seems to have stabilised at 5%. This is a classical definition of a “great moderation”, the U.S. economy is essentially in a sweet spot.

In the attached GIS publication we argue that the recent flattening of the 2/10 yield curve is driven by improving economic fundamentals and falling term premiums. Given the U.S. Net International Investment Position of more than $ 7.0 trillion, the Fed has to be very careful not to scare foreign investors. This global economic recovery will not be led by higher world trade growth. Instead, consumer spending in most oil importing economies will continue to accelerate, CapEx will then kick in (CapEx always lags consumer spending), and only then will we see an increase in global trade growth. Finally, we draw a quick parallel between Canada’s 1995 Quebec separation referendum and today’s Brexit, in terms of market reaction before and after.

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