Brexit and Italian populism have long worried financial markets and been seen by contrarian investors as potential buying opportunities. The latest political developments in Rome and London are for now rewarding buyers of Italian assets, while the UK remains unloved in the bargain basement.
The latest push lower in global sovereign bond yields today was led by Italian paper, buoyed by the prospect of a new coalition government. Italy’s 10-year yield fell below 1 per cent for the first time, while 30-year bonds were on the cusp of breaking below 2 per cent.
Italy’s bond yields have subsequently edged up from their earlier lows today, but Italian debt has room to catch up with the pack if a new government can form and more importantly survive (a big if) in the current world of shrivelling fixed income. Particularly when there’s the expectation of renewed bond buying from the European Central Bank arriving soon. Also of note, Italy’s banks are benefiting, leading the Milan share market higher and helping keep the Euro Stoxx bank index above its recent lows.
Earlier this month the Italian 10-year yield jumped above 1.80 per cent as the previous coalition government fell apart, an outcome triggered by Matteo Salvini, the former deputy prime minister and leader of the far-right League, who was and remains intent on seeking an early election as his party is popular in opinion polls.
The current bullish market sentiment may well face a test and soon.
Hubert de Barochez at Capital Economics says a new government “would have only a slim majority in parliament and would combine two parties that have historically been at odds with each other” and faces the likelihood of not lasting until the next general election due in 2023.
“All that means that there remains a high probability in our view that Italians will return to the polls in the coming months. If, by then, Mr Salvini is still largely ahead in the polls, we wouldn’t be surprised to see the current rally go into reverse, given his antagonism with the EU.”
Over in the UK, politics also dominates the financial market backdrop as Boris Johnson plays hard ball with members of parliament who are seeking to stop the UK from crashing out of the EU without a withdrawal deal on October 31. Here’s a good FT explainer on the rationale behind the move by the UK prime minister to suspended parliament for up to five weeks. This gambit is seen stemming efforts by members of parliament to halt a no-deal Brexit at the end of October, when the current deadline for the UK leaving the EU expires.
Mr Johnson’s stratagem was enough to knock the pound by 1.2 per cent and take the shine off a recent recovery in its fortunes. A more interesting market observation is that demand for insurance against a bigger drop in the pound was already well entrenched before today’s political shock, when looking at positioning in the currency options market, as shown here:
Implied currency volatility over the next three months (which includes Halloween) has extended a climb that began in July and has propelled this measure back to a level last seen in January, highlighted here from FastFT’s Philip Georgiadis, but below the peaks of 2019 and 2016:
The relatively muted reaction today from the currency market is that the risk of a nasty Brexit outcome appears priced over the next three months. UK gilt yields are lower as worries over the economy offset higher inflation expectations, while as usual the FTSE 100’s global members are buoyed by a weaker currency.
David Riley at BlueBay Asset Management argues:
“But even though the probability of a ‘no deal’ Brexit has risen so has the likelihood of an early general election and extension to the Brexit deadline as political space for the ‘soft Brexit’ option is squeezed out.”
“Investors will be wary of taking big directional bets on sterling assets against such an uncertain and binary outcome.”
That likely leaves UK assets languishing, while Italy for now rewards contrarians.
Quick Hits — What’s on the markets radar
Tariffs and the renminbi — This chart via Société Générale highlights the scope for further weakness in China’s currency to offset the affect of US tariffs. The bank notes:
“RMB depreciation has been mostly reactive and defensive, and Beijing has not allowed the RMB to weaken more than justified by tariffs — either implemented or threatened.”
Only the threat of capital outflows and the reliance of Chinese companies for US dollar funding stands to contain a weaker renminbi. The other side of the coin, explains SocGen:
“There could be an earlier move or even an overshoot in USD-CNY above Rmb7.50 [to the dollar] if currently threatened tariffs are implemented, global sentiment sours, and growth fundamentals deteriorate further. A move toward Rmb8 is not inconceivable if the US raises tariffs to 30 per cent on all Chinese imports.”
New record low for 30-year US Treasury yields — A drop towards 1.90 per cent earlier today has faded, but that still leaves the “long bond” below that of the 12-month trailing S&P 500 dividend of 1.98 per cent, a divergence previously seen during the financial crisis.
This would suggest a rotation from bonds towards equities has merit, as the US economy is still growing, but investors need to keep an eye on earnings.
As FT Markets’ Richard Henderson writes, S&P 500 earnings growth for this year has been cut to 2.4 per cent on a per-share basis this year, down from the 7.7 per cent growth expected at the start of the year, according to FactSet data. That’s the largest drop for profit expectations since 2016, and the risk is that this trend extends in the coming months.
The 30-year Treasury yield also sits well below the 2.56 per cent being paid out by the “Dividend Aristocrats”, the 57 S&P 500 blue-chip companies that have increased their payout each year for the past quarter of a century. Quite an exclusive club and it includes the likes of 3M, McDonald’s, Johnson & Johnson and Exxon. For dividend hunters this group of blue-chips may look more appealing.