The Italian Job
Bond market gyrations continue with the latest episode triggered by political machinations in Italy. Having voted for “populist” parties the voters were informed by the Itlaian president, appointed some years back by a very pro EU government, that, in their own interests, whether it was the people’s or the pro-EU faction was not entirly clear, he would not allow the appointment of Paulo Savona, as an anti austerity, anti euro finance minister, proposed by the then PM in waiting, Guiseppe Conte.
Conte promptly “resigned” and the President then appointed a technocrat PM; a former IMF employee and generally pro EU good guy. Italian yields “soared”, although the chart above does put things into perspective. Interestingly, pre euro in the mid 90s, Italian yields were well into the teens as were those of Spain, Portugal and Greece. With further elections on the horizon and the likelihood of the populists getting a much bigger majority, putting the future of the euro currency “experiment” in jeopardy, bond markets were no doubt contemplating those earlier double digit yields.
In the darkest of hours never doubt the EU hierachy’s ability to pull a rabbit out of the bag. After much wrangling, arm twisting and oil burning, Conte was back in the PMs seat with Giovanni Tria named as finance minster in place of Savona. Tria is expected to be far more moderate (read: “not Euroskeptic”) than Savona; and the moment his nomination was announced earlier in the day it allegedly sparked a sharp rally in Italian bonds and stocks. We say allegedly, as at the same time the Italian Minisitry of Finance announced it had sold €500 millon of 2 year Italian BTPs (government bonds) which was a much more likely cause. In effect they said “look we have solved the problem, everyone wants Italian paper, nothing to worry about.” What they glossed over was that it was actually the Italian Treasury department that had provided the funding. This game is not over by a long chalk.
While Italian yields were rising, most other bond markets were reassuming their traditional risk off mode. We doubt that this is anything other than temporary as inflationary pressures rise – oil being the main culprit – and the Fed girds its loins to raise rates later this month. Equity markets have become more volatile again and with geo political tensions abounding we would not be surprised to see another lurch downwards. We are also concerned at the gulf between hard and soft economic news coming out of the US. The soft data is generally formed from surveys where human nature, more often than not, expresses itself by being overly optimistic; Conference Board Consumer Expectations, Small Business Optimism, ISM manufacturing Index, ISM Consumer index. The hard data, “real” numbers, is giving a different picture. Real construction spending, single family home sales, real retail sales, real imports and light vehicle sales are all showing signs of contracting; we believe a recession is coming.
Retail sales, consumer confidence and business investment all remain lacklustre at best, yet the UK equity index made a new high in May. We can put this down almost entirely to the strength of the dollar which makes the UK a more attractive place for foreigners to invest and boosts the earnings of many index constituents whose global earnings are expressed in dollars. The ongoing fudge over Brexit has also helped contrary to perceived wisdom. A soft exit looks increasingly likely, which is good for the City in the short term, but May needs to be careful of a populist backlash and any resurgence in Labour’s election hopes; something that looks unlikely and is encouraging her “Remainer” approach to the “negotiations”; the EU doesn’t “negotiate” but this seems to be lost on her and her followers.
The S&P 500 is again attacking the 200-day moving average, and the pattern of lower highs remains discouraging.
We have already mentioned the disparity in the economic data, which is not being helped by Trump’s trade “negotiations”. He has taken a leaf from the EU book and essentially pronounces with, apparently, very little thought for the outcome.
The quotas imposed on aluminium and steel products are already being seen as a tax on the US consumer. Since Q4 2017 US steel futures have risen by 50%. In part this is due to China cutting back on production, but the inflationary effects are there for all to see. All eyes are on the FOMC meeting for a pronouncement on interest rates on the 13th June. Have they seen signs of the economy softening or do they need to raise rates before the recession starts?
Courtesy of Italy, European banks are back in the spotlight, but not in a good way. Italian banks themselves have lead the charge to lower prices as they are significant holders of BTPs as are the large French and German banks – Deutsche Bank has now fallen by 92% since its share price peak in April 2007. Very few companies make a comeback after that kind of fall from grace.
The other worry is the Target 2 imbalances. Euro nations will from time to time have positive or negative balances with each other and this is dealt with by the ECB through the Target 2 mechanism. Risk off money leaving Italy and flowing mainly to Germany will show up effectively as a liability to the German taxpayer. Mrs Merkel probably hasn’t made that very clear to her electorate…and whilst everyone is worrying about Italy did anyone notice that the Spanish PM has resigned following a no confidence vote; the dominoes are falling.
The Topix 2nd Section – Japanese mid cap and domestic stocks in the main – is at a critical juncture at the psychologically important 7000 level, and the 200-day moving average.
The TSE2 normally leads the Nikkei, so this an important index to watch. The very strongly held consensus view (one not shared by us) is that the US dollar will regain its strength: in the medium term. This of course helps Japanese exporters; not something Mr Trump will likely put up with for very long. If Japan is to regain its former status, however, the Yen may well be the currency to own, along with domestic companies.
Asia Pacific and Emerging Markets
Another index at a critical level and looks to be rolling over beneath a falling 200 day MAV. Both market sectors are heavily influenced by the moves in the US dollar index, and, as has already been alluded, the consensus is that the US dollar will strengthen. In the short term this seems to be the case, which will provide an opportunity to add exposure on a market pull back. Long term the demographics of this region are the big positive. The Asia Pacific chart shows a very similar pattern.
Commodities and Gold
Gold had a strong year in 2017, also helped by the relative weakness of the dollar. If the consensus view on the greenback fails to materialise then it could be a very good 2018 too; particularly for mining stocks, which still languish at lows relative to the gold price – the green line on the chart.
The oil price is becoming very over-extended to the upside and we expect a correction to the MAV before resuming the uptrend. The implications for the global economy in the short term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices.
Commodities in general have been out of favour for some time as the chart of the GS Commodity index relative to the S&P 500 clearly shows. A rising line indicates commodities outperforming the S&P and vice-versa. Given our views on the US equity markets and the bullish potential for gold and oil, this trend could be about to change. Commodity plays are good providers of portfolio diversification and will do well in an inflationary environment.
A schizophrenic month for bonds with Italy leading the charge towards higher rates for the less economically strong countries; EU Southern Med, Turkey, Brazil and dollar denominated emerging market debt in general. In the US, UK, Germany and Japan the move has been the other way in risk off mode. Ex another financial crisis which is not entirely out of the question – see the comments on Europe – we expect yields to continue to rise as the Fed pursues its goal of three rate rises this year; they could be making a huge mistake but that’s what central banks inevitably end up doing; hence our preference for the barbarous relic over bonds with negative real yields.
Central bank rhetoric has changed, and options for withdrawing QE are on the table while rate rises in the States are rising apace. As usual central bankers caveat their prognostications and are likely to return with further accommodation, if asset markets show any serious weakness. We doubt that such an outcome would be as well received as the central banks anticipate…
- Government bonds are heroically expensive – the trend in rates appears to be on the turn.
- Spreads on corporate bonds are still tight and several European issues are trading on negative redemption yields. On that basis, they are ridiculously expensive and default risk can only rise from here, also making high yield potentially less attractive. Is the yield premium adequate? It would appear not, given the increasing level of selling seen in this sector. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing.
- Western equity markets are long overdue a correction; have we had it? The jury is still out.
- Property is attractive, as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise.
- Draghi is slowly removing the QE punch bowl with the final bond purchases scheduled for December. It is unlikely, however, that the ECB would allow things to get out of hand: but how well will any response be executed? The Nikkei index has pulled back to the 21,000 region and looks poised to move higher; domestic issues are preferred. Emerging and Asia Pacific markets are not overly expensive as a long-term position, but they will nevertheless continue to be volatile and affected by dollar machinations and Chinese economic weakness.
- Demand for the physical metal continues to be strong, and sentiment is returning with new gold markets having opened in Shanghai and Dubai, mindful of the world contemplating the latest North Korean threat. Mining shares are not unattractive.
- Commodities have potentially reached a bottom relative to equity markets.
- Not for the first time in recent history, sovereign bond yields are rising on expectations of higher interest rates. Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. We observe closely for signs of success… or failure.
Clive Hale – 1st June 2018
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