Investment Newsletter June 2018
The Italian Job Every four years the regular research reports and newsletters we receive begin to shoehorn in as many football references as possible! Unfortunately for the marketing department, the biggest story in the financial world at present involves Italy. Italy won’t be having an impact at Russia 2018 having failed to qualify, but their recent impact on markets has been significant.
Mike Deverell Investment Manager
Equilibrium Investment Management
At their general election in March, no party won an overall majority leaving Italy without a government. However, after much negotiation, two so-called anti-establishment parties have been able to form a coalition government. The left wing Five Star movement and the right wing League have little in common, except for their stance on immigration and the EU.
The formation of this coalition caused jitters throughout the financial world given that both parties have in the past speculated about leaving the Euro. This would be a concern not least because if Italy redenominates its debts in a new currency worth less than the Euro, then the impact would be the same as if they defaulted on their debts. Therefore, we have seen a sharp sell-off in Italian assets. Chart 1 shows the yield on the Italian two-year government bond. Until May if you had lent your money to the Italian government for two years you would receive a negative yield (you would have to pay them!). Despite this, demand was strong with many European institutions happy to lose money as it would still deliver a better return on cash compared to even lower negative interest rates in some other countries. In addition, the bond is guaranteed by the Italian government so was seen (until recently) as relatively safe.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter June 2018
However, concern that the Italian government might not honour that guarantee saw things change very quickly. Chart 1 shows the yield on the two-year bond quickly spiked up to 2.5% pa, meaning the market price of the bonds fell sharply.
This illustrates that political risks in Europe are never far away. For instance, at present investors don’t seem worried about the Spanish Prime Minister stepping down, ongoing issues in Greece and the impact Brexit could have on the EU Budget.
More recently, the Italian finance minister has affirmed his government’s commitment to the Euro which has calmed market jitters somewhat. The cost of leaving the Euro would be massive and leave Italy in a huge financial crisis.
The events in Italy have also brought to the fore another risk particularly prevalent in Europe (but also globally), which is the way monetary policy interacts with asset markets.
Following this commitment, the yield on the two-year bond has fallen back to around 1%, showing more confidence, but still a degree of nervousness.
Chart 1: Yield on the Italian two-year government bond
Yeild %
Source: Reuters, Adam Samson / FT
On the QT
We’ve recently highlighted our concerns about quantitative tightening (QT) which is essentially the opposite of quantitative easing (QE). As a reminder, QE works when a central bank electronically creates new money which is then used to buy bonds on the open market. The US central bank are actively reversing their QE programme by doing the opposite (when a bond they hold matures, they cancel that money and remove it from the financial system). In Europe, QE is ongoing but it is likely that this will cease at some point this year. It is possible that this could have a big impact on the bond market given a large buyer will be stepping back.
The other concern is that this could disproportionately hurt countries like Italy given the current reluctance of other investors to buy their debt. The worst case scenario is this interaction of monetary policy and political concerns causes a much steeper sell off in bonds, raising the cost of borrowing for countries like Italy. This could then negatively impact their economy, in turn putting pressure on their finances, giving us something of a vicious spiral. We live in a globally integrated financial world and such a scenario would have a real impact on not just Italian banks but the banking system globally. If Italy were to default on its debt then we could be looking at a new financial crisis. Luckily, we believe that is extremely unlikely.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter June 2018
However, the shares of some of the biggest banks have underperformed recently. Chart 2 shows the performance of what are termed “Systemically Important Financial Institutions” relative to the US stockmarket. These are the biggest and most important banks in the world, which cannot be allowed to fail due to the potential impact on the rest of the financial system. As a result they are therefore subject to much more stringent regulation. The share prices of these banks have struggled as investors lose confidence. Big European banks are some of the worst performers with high Italian exposure - however the underperformance is probably more to do with the liquidity squeeze caused by QT.
If the European Central Bank then halts their own QE this could exacerbate these issues. Unlike in the US where growth is robust and the banking system well capitalised, recent economic data out of Europe has been disappointing. Halting QE when the economy is losing momentum is a risk to economic as well as market strength, and could exacerbate issues in Italy. It could well be something of an own goal.
QT means the US money supply (the number of available dollars) is essentially shrinking. Meanwhile demand for those dollars is at a premium as US companies repatriate cash following Trump’s tax reforms. The system is no longer awash with cash as it has been over the past few years, which has helped banks and added fuel to the stockmarket’s fire. Meanwhile short term interest rates may be going up in the US but long term rates have barely moved. Banks make more money when the difference between the two rates is large, by borrowing short term at low rates and lending long term at high rates. This spread is currently very low, making it harder for those banks to profit from this strategy.
Chart 2: SIFIs relative to S&P 500 S&P 500
ASR SIFIS
Source: FT / Absolute Strategy Research
(Sifis = Systemically Important Financial Institutions)
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter June 2018
Spurious correlations, part deux
Last month’s newsletter looked at both the importance and the dangers of using historic correlations in investing. We also looked at some spurious correlations. Goldman Sachs has excelled themselves with their recent 49 page (!) analysis on the World Cup. Apparently, there is a correlation between a country’s average temperature and the amount of times they have appeared in a World Cup final. Although, as Chart 3 shows, Germany rather ruins the pattern…
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium investment management team. The commentary in this newsletter in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader. Your Investment can fall as well as rise and the return of capital cannot be guaranteed.
Average temperature, 1930-2015 (Celsuis degrees)
Chart 3: Correlation between Temperature and World Cup final appearances
Number of times in world cup final Source: FISA, World Bank, Goldman Sachs Global Investment Research
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter June 2018
General Economic Overview The global economy continues to grow and in particular remains strong in the US. In Europe and the UK the picture is a bit more disappointing with data coming in below the market’s expectations. In the UK, interest rates will likely remain on hold for the next few months after weak growth in 2018 so far. Inflation has fallen back but remains above the Bank of England’s target.
Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets Markets have rallied from their falls earlier this year, but jitters remain. We continue to see more value in Asia including China and Japan, and smaller companies within the UK.
Score
-3
Fixed Interest Whilst we expect little in the way of rate increases in the UK they continue to rise in the US. We prefer corporate bonds to government bonds given their higher yields. We expect low but positive returns from fixed interest over the next 18 months.
-4
Commercial Property Prospects for the asset class are mixed. We still wish to avoid London offices and much of the retail sector. However, we are more optimistic about other cities and in the industrial sector. Our selective approach limits the amount we are able to invest in property at present.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-3 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent EIM’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.