Acta Non Verba

Global CIO Commentary by Scott Minerd

Now is the time for strong action from the European Central Bank, as policymakers meet on Thursday to decide how to combat low inflation and muted credit growth. With euro zone inflation at just over one quarter of its target, the ECB is under pressure to act. My advice for Dr. Mario Draghi and his fellow policymakers is to use the big bazooka, to take a shock-and-awe approach, and promise more action if needed. Whether the ECB proposes negative deposit rates, a new Long Term Refinancing Operation (LTRO) or another option; over the coming months, European monetary policy will likely help drive interest rates lower and the U.S. dollar higher.

European quantitative easing, whatever its form, will likely drive yields down, sending money elsewhere in search of yield and forcing the euro currency below its current level of 1.36 U.S. dollars. Of course, this will likely drive even more capital toward the United States. That could prompt a decline in U.S. Treasury yields over the summer, at a time when investors would otherwise expect interest rates to be rising because of an improving American economy and tentative signs of an uptick in U.S. inflation.

On balance, the U.S. economy continues to do well; with central bank liquidity flowing into global markets, the investment environment remains positive for bonds, equities, and credit. Last week, first-quarter U.S. GDP was revised lower to -1 percent, the first negative reading after three uninterrupted years of economic expansion. However, investors need not be alarmed. The GDP revision reflected the effect of the severe winter soft patch, which hit fixed investment and inventories particularly hard. Importantly, consumer spending, which accounts for 70 percent of U.S. economic activity, grew at 3.1 percent and is a better reflection of the underlying strength of the American economy. Of course, we must be conscious that we may well be moving into the realm of markets overheating. It is important to remember that with careful market analysis, speculative markets are often the most rewarding.

Taylor Rule Suggests Further Euro Zone Monetary Accommodation

Most central banks in major advanced economies are running ultra-loose monetary policies, with the exception of the European Central Bank in the euro zone. According to the Taylor Rule, which measures optimal interest rates based on inflation and labor market conditions, the euro zone is the only advanced economy running at a higher policy rate than the rule suggests. To date, the huge divergence in economic fundamentals between core and periphery nations has prevented the ECB from conducting more monetary accommodation. With elevated unemployment and a rising risk of deflation however, ECB policymakers have gradually shifted toward an easing bias, which should be apparent at Thursday’s meeting.

CENTRAL BANK RATES IN MAJOR ADVANCED ECONOMIES VS. TAYLOR RULE SUGGESTED RATES*

Source: Bloomberg, Guggenheim Investments. Data as of 6/4/2014. *Note: We use the same coefficients in the baseline Taylor Rule model for all countries to make the comparison more useful.

Economic Data Releases

U.S. Data Mostly Positive Ahead of Payrolls Report

• The ISM manufacturing index rose in May to 55.4 from 54.9 as new orders and production were both strong.
• The ISM non-manufacturing index increased for a third consecutive month to 56.3, a nine-month high.
• Personal income rose for a fourth consecutive month in April, while consumption decreased for the first time in a year.

• Construction spending rose 0.2 percent in April, with gains concentrated in the non-residential sector. Residential construction fell for the first time since October.
• The trade deficit widened more than expected in April, rising to -$47.2 billion from -$44.2 billion, a two-year high.

Euro Zone Disinflation Adds to Case for ECB Action

• Euro zone aggregate GDP rose 0.2 percent in the first quarter, led by investment spending.
• The euro zone manufacturing PMI was revised downward in the final estimate for May, falling to 52.2.
• Euro zone consumer prices decreased more than expected in May to 0.5 percent from a year ago, back to a multi-year low.
• Germany’s CPI fell more than expected in May, dropping from 1.1 percent year-over-year to 0.6 percent, adding to the case for ECB action on Thursday.

• Retail sales in Germany unexpectedly fell 0.9 percent in April after rising the three previous months.
• The manufacturing PMI in the United Kingdom cooled slightly in May, down to 57.0 from 57.3.
• Japan’s CPI surged to 3.4 percent in April, reaching a 23-year high due to the sales tax increase.
• Japanese industrial production fell more than expected in April, down 2.5 percent.

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