We are closing out another volatile week in financial markets with the primary focus on China and Italy.
In terms of market numbers, two dominate. Are we going to see China’s currency weaken towards and break Rmb7 against the dollar? As for Italy, the prospect of its 10-year government bond yield rising 4 percentage points above a 10-year German Bund also appears on the cards. Also today we finally saw some pressure in Spain and Portugal, so the contagion light is flickering.
Aside from the two pressure points of China and Italy in the global financial system, US equities are carving out a correction and establishing a bottom for the S&P 500 index and other benchmarks, Nasdaq and the Russell 2000 index of small-caps
I really start to worry when there is scope for several market shocks to reverberate at the same time and feed off each other.
Let’s start with China and today’s very volatile equity market. The CSI 300 index at one stage fell 1.2 per cent and approached 3,000 points (its lowest level since March 2016) only to end the day up 3 per cent at 3,134.95. That leaves the market some 29 per cent below its peak in January. Chinese regulators sought to calm investors as detailed here by the FT, clearly rattled by the initial market reaction to news that the economy was softer than expected. China like General Electric in its heyday, doesn’t miss forecasts, so that’s a big deal. The sharp recovery in shares this afternoon also smacks of state-directed buying, behaviour we have seen before.
China’s central bank, the banking and insurance regulator and the securities watchdog are right to be worried. This is a nasty bear market in China and one hurting an economy that has relied on equity prices as a form of collateral for borrowing and speculating.
Alan Ruskin at Deutsche Bank highlights how Beijing would like to support both equities and the renminbi, but in practice it needs to choose one side. Supporting the currency means draining liquidity and that hurts equities and only inflames the pain of margin calls.
This suggests further equity weakness as China seeks to hold the line for its currency, but ultimately a further slide in share prices undermines the economy and the renminbi.
Turning to Italy, what are we waiting for?
Yet another ring-a-ding day for Italian assets as the 10-year bond yield zoomed to 3.8 per cent and then was below 3.5 per cent in late trade. That helped bring “Lo spread” back to 3 percentage points over the German Bund. The FT’s Miles Johnson explains how “Lo spread” is playing out on the streets of Rome via this video.
The recovery in Italian markets stemmed from a more conciliatory tone from an EU official, but neither side appears willing to back down. Big sell-offs beget strong short covering rallies.
By the end of play on Monday, we should have heard from Rome in response to the EU’s stern letter about the Italian government’s draft budget. Don’t expect a good answer, and that means the markets will focus on whether the EU tells Rome to formally revise the budget. On Friday next week S&P Global is due to review Italy’s triple-B credit rating, while at the end of the month Moody’s will complete its review.
A downgrade will leave Italian bonds close to junk status, spurring more investors to pull away should the country appear likely via the political tussle with the EU to lose its investment grade rating.
“We expect Moody’s to cut Italy’s credit rating by one notch and assign a stable outlook, while S&P will probably change its rating outlook from stable to negative (though there is a chance of a one-notch downgrade with stable outlook).”
After next week’s meeting of the European Central Bank governing council, president Mario Draghi will face questions about Italy and rising bond yields.
RBC Capital Markets note:
“The ECB has almost no tools available at this stage that could cause any conciliatory reaction in the market — even if it was willing to intervene which we believe is unlikely.”
That may change if contagion spreads. Spain’s 10-year yield today rose to 1.82 per cent, just shy of the peak seen in March 2017. Portugal topped out at 2.09 per cent, a five-month peak.
The greater contagion risk is banks. The troubles facing Italian lenders are well-known with shares in the sector today hitting their lowest level since early 2017. Less so, perhaps, those of French banks.
David Owen, chief European economist at Jefferies International, wrote this week:
“When thinking about possible contagion from Italy, the French banking sector is very much the outlier.”
Citing the Bank for International Settlements from the first quarter of this year, David points out that French bank exposure to Italy is about 11 per cent of gross domestic product and “skewed towards loans”.
He adds that the exposure of French banks to Italy is much higher than their exposure to Greece in 2009:
“At its peak the French banking sector’s exposure to Greece was over $75bn. The equivalent figure for their exposure to Italy in Q1 was almost $320bn, with another $50bn of credit commitments and $20bn of guarantees extended.”
As for “Lo spread” here’s Chris Iggo at Axa:
“The peak of the spread in December 2011, at 528 [basis points], is closer to where we are today than the tightest post-crisis level of just below 100bp seen in 2015. Either the EU has to soften its opposition to the proposed increase in the Italian deficit or the populist coalition in Rome has to row back on promises it made in the election earlier this year, which at the moment does not seem likely.”
Quick Hits — what’s on the market radar
The fear indicator Bank of America’s weekly flow show on a Friday usually contains something interesting. Here it charts that private clients are dashing for cash with Treasury bill allocation as a percentage of holdings at a 10-year high of 2.8 per cent.
Meanwhile, the bank notes $11bn in outflows from financials over the past seven months, after $32bn in inflows since January 2017. For tech, there has been $2bn in redemptions over the past four weeks, after $42bn in inflows since the start of last year.
St Louis Fed financial stress index It remains in accommodative territory — not applying the brakes to the economy — but worth watching as the index has climbed to a three-month high this week.
China real estate shares Thanks to Ian Harnett at Absolute Strategy for this nice chart which shows they are not enjoying life right now. Given the positive correlation to Chinese interbank rates, Ian says their level suggests there is a pretty major liquidity squeeze taking place.