The tempest

Italian politics rattled European bond markets in May and Italian debt markets still haven’t fully recovered their losses. Our chief investment officer, Julian Chillingworth, warns there could be more turmoil to come.

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The Italian political crisis of late May turned out to be a storm in an espresso cup.

Damaging policies dreamed up by the right-wing/left-wing coalition sent Italian debt yields upward at a gallop. Then the President vetoed prospective Cabinet members and yields really took off. The two-year government bond got as high as 2.77% in the last week of the month; it was -0.25% a month ago. At the time of writing, that had calmed somewhat to about 1.09%. As for the 10-year yield, it got as high as 3.16% on 29 May and it’s now around 2.83%.

So investors were at first scared of a broad coalition of Italian radicals, then more scared that  they didn’t get to appoint the people they wanted. Investors then seemed terrified that a safe pair of hands was offered up. Once the spendthrift policies were back on the table for the world’s second-most indebted developed nation, markets calmed down. What does this tell us? Markets are batty? Perhaps the most enlightening aspect of this episode is the edginess of investors. A whole bunch of bondholders appear to have had their eyes on the door and they dashed for it at the first sign of trouble. These were some astonishing moves in little more than a week.

There are a few good reasons for this nervousness. Large swathes of Italian sovereign debt are owned by retail investors and the prospect of them taking big losses on their safest investments is worrying for the economy, Italians and their politics. Also, most Italian banks, weak as they are, hold much of their regulatory capital in Italian debt. That means a collapse in bond prices could trigger a banking crisis as well.

Of course, last week’s moves will have been intensified by trend-following algorithmic trading and stop-loss programs. Volatility, when it comes, is flurried, fevered even. And traders seem to care more about change than about fundamentals – you can almost see the binary code on the tape.

Meanwhile, Spanish Prime Minister Mariano Rajoy lost a confidence vote called after his party was embroiled in an historic campaign slush fund scandal. Mr Rajoy’s successor is Socialist Party leader and economist Pedro Sanchez, who is now trying to consolidate a rag-tag bag of small opposition parties into a functioning government. If he fails to bind the gamut of conflicting parties, Spain will probably be heading back to the polls later this year. The Spanish two-year debt yield jumped significantly as Mr Rajoy departed, but quickly recovered most of its ground. Still, the short-term debt remained in negative territory, it briefly hit 0% before dropping back to -0.22%.

With the European Central Bank (ECB) laying so much buying pressure on Continental bonds, we believe the euro is the best barometer of foreign capital’s view on the EU and its prospects. The currency market is just way too large for the central bank to have any effect so we think it offers a more helpful picture. The trade-weighted euro took a 3% dip in May after 10 months of reasonably constant value.

And following month-end, the ECB has been hinting that it may be about to reduce the amount of bonds it buys each month. Taking advantage of a healthier economy to reduce the truly monumental distortions of extraordinary monetary policy makes sense, but the central bank will have to be careful that it doesn’t spark a run on some of the bloc’s weaker sovereign debt markets.

We think more turmoil could be bubbling under the surface of European debt markets.

Index

1 month

3 months

6 months

1 year

FTSE All-Share

2.8%

7.4%

6.7%

6.5%

FTSE 100

2.8%

7.6%

7.0%

6.3%

FTSE 250

3.1%

7.0%

5.9%

7.2%

FTSE SmallCap

1.5%

4.9%

4.3%

7.9%

S&P 500

5.9%

3.6%

4.6%

10.3%

Euro Stoxx

-1.2%

0.8%

-0.3%

3.1%

Topix

2.4%

1.4%

3.3%

12.4%

Shanghai SE

3.2%

-2.7%

-2.0%

2.7%

FTSE Emerging

-0.2%

-3.7%

2.7%

9.2%

Source: FE Analytics, data sterling total return to 31 May

 

My ol’ mate, Brent

Shrugging off steadily worsening economic data, the FTSE 100 hit a record high of 7,877.5 on 22 May.

Large-cap UK companies have been boosted by the oil price hitting $80 a barrel – the highest level in four years. Greater sanctions on Iran have turned off the taps for some of the world’s largest oilfields before they even started to get going again. Another Middle Eastern exporter, Qatar, is also labouring under sanctions, while the Opec cartel is doing a stand-up job of curtailing production. Venezuela’s production is in freefall as the badly managed country disintegrates like a paper bag in the rain.

As for US shale oil producers, while they have been increasing output to make the most of higher prices, it hasn’t been the anchor on prices that some thought it would. The US Energy Information Agency (EIA) expects US production to jump 15% this year, followed by an 11% rise in 2019. In some places, technological improvements are allowing the drillers to extract oil and gas up to a third faster than before. However, there are prosaic impediments to a shale oil revolution. It’s becoming harder to find skilled workers for projects in the middle of nowhere. Labour rates are rising, as is the cost of the water that’s needed to put the hydro in hydraulic fracturing. And there are also bottlenecks for getting oil and gas to customers: for a really dramatic uptick in shale oil production there would need to be a significant investment in pipelines to move the gas and oil to market. That will take time and money, so it could be a handbrake on exceptional increases in production for the next year or so.

It’s not just supply pressures squeezing the oil price higher either. The US is positively booming, according to both the data and our analysts recently back from a trip across the pond. Companies are busy and profitable, and it appears the recent tax cuts have been shared with workers in the form of stock awards and cash bonuses. All this has set off a wave of confidence in America that should flow through to the global economy as well. It probably already is, with Europe recovering from its long recession and Asian growth humming. That’s pushing up the price of oil and raw materials even further.

As long as China and the US don’t get into an aggressive and escalating trade war, greater confidence on America’s Main Streets should mean greater demand for the world’s factories in Asia. And that would mean more orders for the, typically, European companies that manufacture the industrial machinery and equipment used in the East. This is idealised somewhat, but broadly this is why the world is so interconnected these days. Everything is intertwined, which is what makes attempts to unravel it unnerving.


Bond Yields

Sovereign 10-year

May 31

Apr 30

UK

1.23%

1.42%

US

2.86%

2.95%

Germany

0.34%

0.56%

Italy

2.77%

1.78%

Japan

0.03%

0.05%

Source: Bloomberg

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