Volatility returns to risk assets

Asset allocation strategy - 6/11/2018

Volatility made a big come back in May amid serious political tension. Investors sold stocks aggressively when Italy’s President refused to approve highly eurosceptic Paolo Savona as finance minister, thereby risking early elections which opinion polls suggested might actually increase support for the Lega.

All eyes on Italy

There were extraordinary prices swings on Italy’s government debt, especially at the short end of the yield curve. Between May 28 and 29, yields on 2-year bonds leapt from 0.28% to 2.78%. But when the President agreed that Savona could stay, but in another post, markets bounced back and 2-year yields ended a crazy week at 1.07%. 

The fact that the new government includes pro-Europeans as well as eurosceptics reassured investors and pushed the risk of early elections into the background. Markets will no doubt remain nervous until there is a clearer idea of the new administration’s agenda and the current significant risk premium will remain. The next step will be to prepare the budget which is expected to come before the assembly in October. 

The Lega and the 5-star movement both made very ambitious election promises to introduce stimulus measures so talks with the European Commission are likely to be very tense. But a consensus should even so be reached as Europe intends to change its approach to the migrant crisis and might adopt some Italian proposals. And there is also some leeway over Italy’s budget. All in all, we believe Italexit risk is limited. During the election campaign, there were no calls to abandon the euro and most Italians still want to keep it. 

In Spain, Mariano Rajoy’s resignation is of local political importance only and is not likely to rekindle the Catalan independence issue.

Key points
  • Slight equity overweight
  • Japanese equity exposure once again reduced
  • Neutral on the US dollar

The ECB weights its words carefully

Protectionist concerns have resurfaced in the US. Import duties are to be imposed on steel and aluminium, talks between China and NAFTA are bogged down and Donald Trump is now threatening to increase tariffs on imported cars. As a result, investors are worried major countries will jump on the protectionist bandwagon. In fact, reinforced US protectionist rhetoric is not that surprising with the mid-term elections due later this year. We still expect the gesticulations to continue but believe they will translate into only a moderate rise in protectionism, i.e. nothing like the trade war so many are worried about.

Against this backdrop, global growth is still on track. Nevertheless, Europe has been slowing since the beginning of 2018 and inflation edged slightly higher in April. Faced with volatile Italian spreads and an upbeat economic environment that is not quite as robust as expected, the ECB is carefully weighing its words so as to prepare investors for its June 14 meeting when it will announce the end of quantitative easing for this year. The message to investors is that Italy’s uncertainties will not derail the bank’s move towards monetary policy normalisation and that it will from now on use its Outright Monetary Transactions (OMT) programme to deal with a local crisis. But if Italian volatility were to turn into a European crisis, the ECB would be forced to abandon its project.

In our asset allocation changes, we took some profits in the middle of the month and halved our European and Japanese equity overweight. More recently, we reduced Japanese equity weightings further and are now at neutral weighting. We did the same for the US dollar. Today’s fundamentally healthy environment dictates high equity exposure -we are still slightly overweight- but recent developments like rising protectionism, Italy’s persistent risk premium (at least until October’s budget) and the prospects of monetary normalisation in Europe all suggest risk assets could be in for more volatility in coming weeks. Hence our decision to turn a little more cautious. We fully intend to maintain our tactical approach to investing in 2018.

    Our convictions for June Changes compared to the previous month
EQUITIES
US
Europe
  Euro
  United-Kingdom
Japan
Emerging countries
FIXED INCOME
US
Euro
Investment Grade
High Yield
Money market
DIVERSIFICATION    
Convertibles bonds
Dollar
Next headline events
  • June 12 & 13: next Fed meeting
  • June 14: next ECB meeting
  • June 14 & 15: next BoJ meeting

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