Previous posts suggested switching from a neutral to defensive stance on equities in response to a fall in a global leading indicator derived from the OECD’s country leading indices. The thinking was that such a decline would confirm the monetary forecast of a slowdown in global growth from the spring, implying increased headwinds for risk assets.

The signal was duly delivered last week – see here – and has been followed by a 4.3% decline in global equities, as measured by the MSCI World index in US dollars. Stocks, however, had already fallen by 6.1% from a 19 March peak, probably reflecting a reescalaton of the Eurozone crisis. Euro woes, in other words, may have advanced and exaggerated the expected risk sell-off.

This, needless to say, complicates investment decision-making. Current equity prices may already discount likely economic weakness – global real money is still expanding, suggesting a slowdown rather than anything worse. A full meltdown of the euro would warrant further falls but the probability of such a scenario is unknowable, depending on the psychology of Spanish and Italian bank depositors as much as, or more than, any decisions by political leaders.

Stocks look short-term oversold based on the put / call ratio and other indicators, while further monetary easing is in train: Chinese repo rates, for example, this week fell to their lowest for a year – see first and second charts. G7 12-month real narrow money growth has yet to cross beneath industrial output expansion, a development that usually precedes major bear phases. There may be a better opportunity to undertake a further defensive shift.

Footnote: An interesting curiosity is that fluctuations in US stocks so far this year resemble those 25 years ago in 1987. A spring sell-off that year bottomed on 21 May and was followed by summer strength before much greater weakness in the autumn – third chart.

The May Inflation Report suggests that more QE is in the offing but the Bank of England is reserving its ammunition until the fall-out from the Eurozone crisis becomes clearer. The Bank, however, continues to deny any responsibility for improving credit conditions, despite believing that credit constraints have contributed to supply-side weakness.

The Report downgraded the Bank’s growth forecast while maintaining a projection of below-target inflation in two years’ time. The mean two-year-ahead inflation expectation based on unchanged policy seems to be 1.8%, the same as in February, based on “eye-balling” the relevant fan chart. This raises the question of why more QE was not announced last week, as suggested by the “MPC-ometer” used here to predict the monthly decision.

One possible explanation is that the Bank felt constrained by another forced upward revision to its shorter-term inflation forecast – the mean projection for the second quarter of 2013, for example, has been raised from 1.65% to an estimated 2.3%. This, however, would be at odds with its usual focus on the two-year horizon, while the Report plays down the significance of the change.

The more likely reason for inaction is that the Bank is waiting for the full horror of the Eurozone crisis to be revealed before calibrating its next programme. Delay, moreover, leaves the door open to co-ordinated action with other central banks, for example in the event of a forced Greek exit from EMU – the Bank may believe this would deliver more “bang for the buck”.

Press reports of faster deposit outflows from Greek banks accord with developments on the ECB’s balance sheet last week.

“Other claims on euro area credit institutions denominated in euro” – a category that includes the Greek and Irish emergency liquidity assistance (ELA) operations – rose by €3.7 billion in the week to Friday. This may reflect Greek banks borrowing more to plug a funding gap created by deposit flight.

Greek banks are unable to increase borrowing under the ECB’s regular programmes (i.e. refinancing operations and the marginal lending facility) because of a lack of higher-quality collateral. Regular lending, however, rose by €7.0 billion last week, possibly indicating capital flight from other peripheral banking systems not currently constrained by a collateral shortage.

The €3.7 billion rise in “other claims” last week compares with a fall of €11.7 billion in Greek deposits during the first quarter. Domestic private sector deposits stood at €170 billion at the end of March, of which €66 billion was in overnight deposits. It is reasonable to expect this instantly-accessible cash to leave the Greek banking system amid current political and economic chaos, implying a heightened risk of deposits being frozen and/or redenominated in the event of EMU expulsion.

Faster capital flight could push Greece out of the euro well before next month’s elections, rendering current political manoeuvring irrelevant. The mechanism would be Greek banks losing access to additional ELA either because they run out of lower-quality collateral or because the Bundesbank and other “core” central banks place a cap on their Target2 exposure – why, after all, should German tax-payers underwrite high-risk lending serving the function of allowing austerity-resistant Greeks to transform deposits in bust domestic banks into Bunds and other “safe” assets?

Officialdom and the consensus cheered sterling’s 2007-08 collapse on the grounds that it would speed economic recovery. Posts at the time suggested that capacity and credit constraints would prevent a major expansion of tradeables output, implying a bigger boost to inflation and consequent squeeze on real incomes and spending – see, for example, here. The net impact on the economy, therefore, would be negative, at least in the short to medium run.

Three years on, there is little reason to revise this assessment. The trade volume response to the lower exchange rate has been muted – net exports strengthened by 0.9% of GDP between the fourth quarters of 2008 and 2011. Non-oil import prices, meanwhile, surged by 8.8% over the same period, implying a 2.6% direct boost to the domestic price level (based on a 29% share of non-oil imports in domestic demand).

Weak wage trends suggest that workers have been unable to obtain compensation for increased prices. The import cost boost, in other words, may have cut real employment incomes by 2.6%. An equivalent impact on consumer spending would imply a GDP drag of 1.6% (based on a 62% share of consumption in GDP), comfortably exceeding the positive contribution from net exports. (This ignores any effect on corporate spending.)

Trade improvement has stalled since early 2011, partly reflecting Eurozone economic weakness. Goods export volumes rose by only 0.3% in the year to the first quarter of 2012, with a fall of 3.3% in deliveries to other EU countries offsetting 4.4% growth to the rest of the world.

Supply-side weaknesses may constrain trade performance even if foreign demand strengthens. The percentage of CBI manufacturers operating below capacity is close to the historical average, while skilled labour shortages have surged. The percentage citing credit or finance as a constraint on exports remains elevated.

The UK’s experience casts doubt on the view expressed in a Financial Times comment piece today that “Greek growth would probably surge” in response to a mega-devaluation following EMU exit. Rather than an unlikely export boom, the case for leaving rests on Greece gaining the ability to calibrate monetary conditions to the needs of the domestic economy. Monetary autonomy, however, might be severely restricted amid the financial chaos likely to accompany departure.

Speculators in US Treasury futures have a poor timing record and last week went long, suggesting a rebound in yields.

The chart aggregates the positions of “non-commercial” investors in four Treasury futures contracts using duration-based weights. Examples of recent poor timing include: 1) a large long position in October 2010 – yields subsequently surged; 2) a large short position in early 2011 – yields subsequently collapsed; and 3) another large short position in March this year ahead of the recent yield decline.

The poor record reflects trend-following behaviour – more precisely, a tendency to invest in trends when they are at a late stage. Speculators are occasionally “bailed out” by events that cause an established trend to extend – a long position adopted in the second half of 2007, for example, benefited from the unfolding financial crisis. Such events, however, need to surprise – current Eurozone woes, presumably, are well-discounted.

Another possible contrarian signal is the swelling consensus that the US bond market is “turning Japanese”, i.e. low nominal yields reflect deflationary excess private saving. Current negative real yields, however, have no parallel in recent Japanese experience and are more plausibly the product of “financial repression” – Federal Reserve imposition of zero interest rates and effective deficit monetisation.