One cannot be blamed for feeling exasperated by the current state of the markets. There are conflicting signals in all corners, some pushing, others pulling – divergences everywhere!

Taking a brief survey of the current state of affairs we find:

  • Central Bank divergence: the Fed has embarked on a hiking cycle while the other Central Banks are firmly standing pat in a dovish mode and only beginning to fiddle with the existing QE programs.
  • Monetary Policy vs. Market Reaction divergence: the Fed has begun sounding out the market on its $4.5trn balance sheet reduction, specifically focusing on reducing its MBS position which increased by $1trn since 2014. The reaction to this in the rates markets? A slow and steady grinding lower in yields.
  • Business Cycle Indicator divergence:  For the first six-month period since the end of the financial crisis the commercial and industrial loans fell on bank balance sheets. This stands in sharp contrast to other coincident and leading indicators of the US economy which are flashing green.
  • Politics vs. Market divergence: After the new administration, the markets rallied in anticipation of pro-growth and business-friendly initiatives such as the corporate tax cuts and infrastructure spending. The Obamacare repeal was intended to release the savings necessary to pay for the corporate tax cuts. When the repeal failed, the markets took in stride, though it is unclear where the savings for the tax cuts will now come from.
  • Hard vs Soft Data divergece: There is an unusual split in the consumer and business sentiment indicators and actual economic activity releases – the sentiment is sky high while actual business activity is ho-hum.
  • Asset Class divergence: Global equities have performed very strongly so far in 2017 while credit spreads and yields have not reflected the same risk appetite.

While we can come up with reasonable explanations for all of the above – the sheer number of apparent divergences seems odd. What does all this mean for investors?

  • We can be looking at the end of the current business, credit and market cycle which tend to feature a significant rise in divergences. If this is the case, then investors should lighten on leverage, acquire some tail risk protection and rebalance towards defensive portions of their portfolios.
  • A rise in divergences can be viewed positively as an opportunty to find alpha – divergences across asset classes benefit the skillful (or lucky) investor.
  • Investors who are averse to tactical trading may be able to take advantage of market divergences by rebalancing their portfolios on any significant deviation from their benchmarks which may allow them to buy assets that have underperformed and sell assets that have outperformed.

Every challenge presents an opportunity.

Good Luck!

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