As if there wasn’t already enough geopolitical tension in the air for financial markets, another round of dysfunctional politics in Europe’s fourth largest economy certainly left an impression. Investors were quick to price-in-expectations when a political and constitutional scare quickly swept through Italy. An uncertain future for the European Union became a highlight of last month in an investment environment already troubled by American trade disputes and North Korea.
Italian bond yields rose swiftly to multi-year new highs when the Italian president refused to swear in a trained economist and Eurosceptic as Italy’s next finance minister. The Italian president’s decision was met with outrage by political activists and may have given two Italian populist groups a larger political foothold. The Italian populist would like anything but Italian austerity, which existing EU members and financial markets both find destabilizing.
Holders of US treasuries and German bunds were the beneficiaries from Italian bond selling. US and German interest rates that were finally gaining altitude this year broke back down below critical support levels during the Italian debacle.
The move is especially meaningful for global central bank policy. Specifically, US central bank policy is raising short-term interest rates. A problem, however, arises when long-term yields fall on geopolitics and the difference between yields on longer-dated and shorter-dated borrowings narrow. What is known as a flattening yield curve becomes especially dangerous if shorter-term yields push past longer-term yields in magnitude.
“Italian bond yields rose swiftly to multi-year new highs when the Italian president refused to swear in a trained economist and Eurosceptic as Italy’s next finance minister.”
Currency markets were not immune to the political juxtaposition in Italy either. A flight to safety ensued in currency markets similar to that of fixed-income markets. Safe haven currencies like the Australian dollar, Japanese yen, and Swiss franc made gains against the US dollar. The US dollar, however, has strengthened against most other trading partners this year. The Canadian dollar, euro, and pound sterling are in losing positions against the US dollar.
No doubt, the US dollar is strong on a better US interest rate environment, but there is more to the story than just yields. That includes things like a robust economy and stock market. For example, corporate earnings experienced record performance in the latest quarter. US companies represented in the S&P 500 put up blended revenue and net earnings growth of nearly 9% and 25%, respectively. Performance figures by technology and energy companies were at the forefront, although energy’s earnings had a low hurdle to clear after last year’s dismal results.
Stocks outside the US, however, are leaning more to the downside. Specifically, emerging market stocks are the most badly bruised. European stocks, on the other hand, are a mixed group. Year-to-date, gains exist in France and Italy, although Italian stocks have given back a majority of their earlier gains. German stocks are down on weaker economic prints, and UK stocks are flat on weaker economic data and BREXIT concerns.
Unlike the US, European corporate revenues and earnings are less impressive. Blended revenues actually contracted and net earnings barely surpassed European inflationary data. That’s not exactly the type of data that stock investors desire.
In any event, a lot remains to be seen this year, especially on the political landscape. The global recovery should not be discounted as being over yet, though there are probably plenty of wild cards left unplayed. In the meantime, the investment environment must balance American trade negotiations and the unpredictable episodes of global governments. Expect risk premiums that affect prices to vary in the near-future as the drama unfolds.