Italian turmoil: just one chapter of the bigger story

Market headlines in the final week of May were dominated by developments in Italian politics. Uncertainty over which parties would lead the country’s government and what policies they would pursue drove some sizeable price swings that extended beyond Italian bonds. We will delve into the details and explore the situation in more detail in our upcoming newsletter. For now, we thought it would be timely to highlight some of the more noteworthy market movements and the relevance to broader risk-sentiment.

The most dramatic reaction to the Italian turmoil has arguably been witnessed in yields for Italian bonds, the fourth largest bond market in the world. As illustrated in Chart 1 below, the 2 year Italian yield spiked an alarming 304bps during the month. This benefited our positioning for a widening in the spread between Italian and German yields. Given the arithmetic of the election results in March, there was never a possibility of a market friendly outcome. The best outcome for the establishment parties was a second election, but in reality this would have just bolstered support for the populist parties. Moreover, while there were echoes of the French election worries that ultimately fizzled last year, as we explore later – the market environment has changed and risk sentiment is more vulnerable than 2017. 

 
Chart 1: Italian 2 year yield

 

 

 

 

 

 

 

 

 

 

 

 

 

Beyond Italy, the sharp correction for risk appetite spread through the region with Spanish bonds suffering a smaller but still significant spike (2 year yields from -34bp to 7bp). Similarly, the region’s common currency endured a 3.2% slide, the largest monthly decline since November 2016. The spill-over effects were also felt in the credit arena, where the cost of protection on European high yield jumped 51bps. This accelerated the trend higher calendar-year-to-date as visible in Chart 2. These sizable moves served our short credit and short Euro exposure well.  

 
Chart 2: European High Yield CDS Credit Spread

 

 

 

 

 

 

 

 

 

 

 

 

 

In terms of the economic landscape, we have previously pointed to reasons why we believe the European growth story has tired and has already turned a corner. This includes the gusting tailwind of strong export growth fading to a breeze as the surge in Chinese imports drops, coupled with the looming effects of trade wars.

While the situation in Europe is likely to continue capturing investors’ attention in the near-term, the real story is one that we have spoken of repeatedly this year, namely; the return of volatility. It is a story driven chiefly by the withdrawal of an unprecedented swell of liquidity in the financial system. A tide that had lifted all asset classes, but more importantly a force that had lured investors to those offering higher yields, which are now those that are the most at risk of an unwind. We won’t rehash all the implications here – our March newsletter discussed some of the dangers in more detail. What is worth emphasising is that the aforementioned moves across Italian bonds and high yield credit are part of this much larger story, which arguably has many more chapters ahead. 

 

Subscribe

This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at June 5, 2018. It is not to be published, or otherwise made available to any person other than the party to whom it is provided.

This article is for general information purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.

The information in this article may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information in this article is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information.

Any projections contained in this article are predictive and should not be relied upon when making an investment decision or recommendation. While we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections.

Related Articles