13 Juni 2018, 13:04 GMT
There have been multiple major political events over the last few weeks. Some have impacted the financial markets, while others are making headlines in the financial press. Here are my thoughts on three big recent events and the investment opportunities they present.
Event 1: Italy
The formation of an anti-establishment coalition government in Italy rocked markets. The successful political parties had pledged to host a referendum on whether Italy should cease using the Euro - a de facto vote to exit the EU. This resulted in a massive negative move in the Italian bond market. In my opinion, it far outweighed the political risk, considering: 1) the referendum may not happen; 2) it is far from clear that the electorate would vote to an EU exit; and 3) even if Italy did leave, how much wider should its bonds’ spread be over German bunds?
For me, the Italian bond price action said more about investor positioning than political risk. It highlights the magnitude of the current ‘reach-for-yield’ mentality of investors who cannot afford capital losses. If the European Central Bank (ECB) needed evidence of abnormal investor behaviour in response to continued ultra-low interest rates, this was it.
The averse investor reaction has offered investment opportunity, but speed is of the essence: the 2-year Italian yield jumped almost 2 per cent on the day of the coalition announcement but retraced much of that a day later. Meanwhile, the 10-year Italian yield broke above 3 per cent but, unlike the 2-year yield, still hovers around 3 per cent as I write. When hedged in US dollars, that translates to 5.5 per cent, which compares favourably to many emerging markets. I believe this represents value.
The speed of the move in Italian yields implied to me that professional institutional investors were involved in the selling frenzy. Presumably, they were holding Italian bonds as a basket of Euro countries. Surely, this is further evidence of the need for Federal level European debt, if the Euro wants to consolidate its role as a reserve currency.
Ever the optimist, I wonder if yet another European member state population railing against the EU as an institution will push it closer to reform, especially regarding flexibility. Who knows - if such reform did occur, the U.K. might even be persuaded to rejoin. But a looming trade war could stifle such a benefit; which brings me to event two.
Event 2: US, Canada, Germany, France, Italy, UK, Japan
Watching the G-7 meeting unfold was fascinating. My view is that slowing levels of potential economic growth inevitably lead to protectionism, as gaining market share becomes more important.
That infamous photo of the world leaders leaning angrily over an indignant President Trump said to me that Trump could win this trade dispute. The huge domestic proportion of the US economy may be enough to give Trump the strongest hand. However, with emotions running this high it’s hard to picture a quick resolution; as the Brexit negotiations show us.
Trade frictions reduce economic efficiency, which lowers potential economic growth. That means lower levels of terminal interest rates, and so lower bond yields. In light of this, a 3 per cent 10-year Treasury bond yield looks like a good buy to me. Certainly, I’m keen to keep bonds in my portfolio to offset equity exposure. With such a strong equity market focus on corporate earnings, I worry about a deteriorating trade dispute. For equity-only investors, risks might be mitigated with a tilt towards domestic companies, preferably with a small-cap bias.
I was disappointed to see President Trump retract the G-7 Communique immediately after leaving Canada. In life, business, and politics, we set a time to negotiate with our partners and use that time to reach agreement, usually with compromise from all parties. Retracting after such meetings renders diplomacy ineffective; which brings me to event three.
Event 3: North Korea
As a member of global society, I was pleased to see the commencement of talks between the US and North Korea. It troubled me that it turned into such a media circus, and I hope that both unorthodox leaders were not swayed by that.
I’m not sure I see an impact either way on global markets. The US appeared to insist that a deal involve complete denuclearisation of the Korean Peninsula. Since this would benefit both sides, I believe they’ll achieve this goal. The natural investment then would be to sell Swiss Francs, but the market has been pricing in this event already: the Swiss Franc is as weak now as when the Swiss National Bank removed the exchange rate floor a few years ago. Perhaps, selling gold is a better bet.
In conclusion, my guidance is to be nimble. Opportunities will arise because these events prompt market moves which are exaggerated by excessive investor risk-taking; behaviour that is driven by overly accommodative central banks. Therefore, all eyes remain on the Federal Reserve and ECB meetings this week.
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