US dollar revival and Italy’s political chaos finally rouse investors to global market risks
Nicholas Spiro says excess liquidity and loose monetary policy left investors sleepwalking through risky market conditions. Italy’s threat to the euro zone and the greenback’s rally have, thankfully, alerted them to the risks
The trading of European government bonds is no longer for the faint-hearted. Last year, the yield on Italy’s two-year debt, which remained in negative territory for most of the year, traded in a super-tight range of some 20 basis points.
On Tuesday, the yield shot up a staggering 180 basis points, to 2.8 per cent, at the time a tad higher than its 10-year US equivalent and the sharpest intraday move since records began in 1992, according to data from Reuters. The sell-off reflected mounting concerns among international investors about Italy’s commitment to Europe’s single currency as the country' s two main anti-establishment parties struggle to form the first populist government in a leading European economy.
Italy’s political crisis, which is rippling through financial markets, is the latest sign that, following a two-year period of subdued volatility and stellar returns, investors are being jolted out of their complacency and forced to reassess risks and vulnerabilities in the global economy.
In the space of just four months, markets have had to contend with a surge in volatility in US stock markets, a sudden end to the period of “synchronised” global growth, a sharp sell-off in emerging markets stemming from an unexpected rise in the dollar and Treasury yields and, to top it all off, renewed concerns about the integrity of the euro zone.
Make no mistake, 2018 is the year of reckoning.
Given the extent to which valuations in global equity and bond markets had become overstretched, and the degree to which ultra-loose monetary policies had desensitised markets to financial and political risks, the recent correction in asset prices and increasing nervousness on the part of investors are no bad thing – quite the opposite.
In a sign of just how somnolent markets were in 2017, the 23 occasions in the first quarter of this year in which the benchmark S&P 500 equity index experienced a daily move of more than 1 per cent were three times the number for the whole of 2017, according to data from Bloomberg. A separate analysis undertaken by the Financial Times showed that the year following the US presidential election in November 2016 was the calmest for the S&P 500 in more than half a century.
This excessive tranquillity was fuelled by an easing of financial conditions in the face of a rise in US interest rates. Yet, now that markets are less stimulative for economic growth, investors are finally becoming more attuned to risks.
Two crucial factors have roused investors from their liquidity-induced stupor: the sharp rally in the dollar and the sudden escalation in political risk in Italy and its implications for the country’s membership of the euro zone.
The greenback’s revival – the dollar index, a gauge of the currency’s performance against a basket of its peers, has shot up more than 5.5 per cent in the past six weeks – has prompted greater scrutiny of emerging market economies’ fundamentals, exposing vulnerabilities in countries with large dollar-denominated debts and significant macroeconomic imbalances, such as Argentina and Turkey.
In a sign of the extent to which investors are now differentiating between developing economies, spreads (or the risk premium) on dollar-denominated Turkish and Argentinian corporate debt – as measured by JPMorgan’s benchmark corporate emerging market bond index – have surged 147 and 100 basis points respectively over the past month. This compares with an increase of just 29 basis points for the broader index.
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The political chaos in Italy has also forced markets to reappraise risks in Europe’s monetary union which, as I explained in an earlier column, remains vulnerable because of the lack of political and fiscal integration within the bloc. Plans by Italy’s two main populist parties to overhaul the economic governance of the euro zone have sowed uncertainty over the country’s membership of the bloc just when the European Central Bank is preparing to end its quantitative easing programme.
If these fears intensify – on Wednesday Italian assets rebounded even though sentiment remained fragile – then it will not just be Italy’s markets that investors have to worry about, but also those of Greece, Portugal and Spain as the singleness of the euro zone is once again called into question.
Still, the fact that investors are starting to assess risks in developing economies and Europe more carefully is one of the healthiest developments in markets in recent years.
Complacency, it appears, is finally on the wane.
Nicholas Spiro is a partner at Lauressa Advisory