On the back of the screeching handbrake turn by main Central Banks (led by the Fed), financial markets are exhibiting signs of extreme confusion: equity investors’ thinking about the Fed still seems to be in “insurance policy” mode, while bond markets are pricing in a much higher likelihood of recession.

Indeed, in May the value of global sovereign bonds with negative yields had doubled since last October to $11 trillion (only $1 trillion below the all-time high registered in mid-2016), while the US Treasury 30-year bond yield has breached the 2017 and 2018 lows

At the same time, the yield curve has inverted again, and it is now much harder to ignore this renewed, downward direction of travel. When the 10 year yield is lower than the 3 month yield, it means that investors are betting on rates being lower in ten years’ time than they are now. Since they are already very low, that is a powerfully deflationary signal.

Justification for this exceptionally gloomy view is not hard to find: The shocking trade attacks on Mexico and India (two very important US allies) within days of each other are clear signs that Trump has decided to take the gamble of latter-day protectionism and to go down a slippery slope.

If the US economy were to slow (and it already is, irrespective of the trade issues), Trump will respond by becoming even more protectionist.

The main danger is a profit recession in the US. The past decade has been great for companies, with record profit margins driven by Iower corporate tax rates, low cost of capital and very moderate wage growth. The issue is not that margins come off a cliff (we will not have inflation all of a sudden), but further improvement in margins are off the table and they are going one way: down

In Europe, the ECB was confronted with slowing economic growth, uncertain politics and wobbly markets, and so it reliably came to the rescue in June with new lending stimulus measures and a deferral of the start to any normalisation of interest rates.

A low-growth, low-inflation environment, along with a negative deposit rate and ample central bank liquidity, bears a striking resemblance to post-bubble Japan

Over the past two years the Eurozone economy has left its “normal” growth path following the global financial crisis and has dipped into the Japanification territory that has characterised that country for the past quarter of a century. Except that it is not Japan:  it is not a cohesive nation state with a joined up central bank and finance ministry operating in tandem.

To sum up, we are heading for a prolonged stagnation, driven as much by political uncertainty as underlying fundamentals


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