By Mark Dowding’s, co-Head of Developed Markets at BlueBay AM
We believe investors are overly bearish on Italy despite the government’s disinterest in pursing a Eurosceptic agenda. Elsewhere, the US-China trade dispute sees no end in sight.
Global bond yields continued to edge higher over the past week as the flight to quality flows reversed, with worries in emerging markets (EM) appearing to abate for the time being.
US tariffs on China seem to have been met with a muted response from Beijing and there appears some hope that most of the bad news is behind us for now, even if there is a lingering sense that the direction of travel is towards further tariffs and protectionist measures in the month ahead. Although US tariffs start at 10% on USD200 billion, these will increase to 25% at the end of the year and we believe that additional measures on a further USD267 billion will likely follow, with the US administration tacitly seeking to limit the rise of Chinese hegemony. Intrinsically, this may act as a fiscal drag on the US economy, yet the impact is likely to be very small and we see US growth lower by only 0.1% and prices higher by only 0.2% in the coming year as a result. Indeed, this will be easily more than offset by the big fiscal push to consumer incomes coming up in the first half of next year.
Instead, the impact of tariffs is likely to be larger in China itself. Chinese growth is already slowing following a positive start to the year and the main question surrounds how eager policymakers will be to support economic activity in the months ahead. GDP growth data seems likely to drop below 6% and could fall further, yet the Chinese economy is in better shape in many regards than was the case when slowdown fears triggered capital outflow in 2016. All this said, with US rates continuing to rise, we believe that the case for a positive dollar versus China would appear to be building.
Elsewhere, higher yields have helped support corporate bond spreads so far this month, with insurance investors seeking to put cash to work amidst heavy seasonal issuance following the summer break. European financials performed well thanks to an improved backdrop in the periphery leading to a rally in bank equities. Robust equity markets and declining volatility is also seeing investors look for assets where valuations appear cheap, yet there remains an underlying sense that the mood could easily darken again, should EM stress return and prompt further position capitulation.
In Europe, Italian bonds have continued to rally as fears related to the budget continue to abate. It would appear that a target deficit between 1.6% and 2.0% of GDP is a likely outcome – and we have argued that those focusing too myopically on this budget issue continue to overlook the fact that the main thing that matters to an Italian government bond (BTP) investor at spreads north of 200bp, is that for the time being, there seems no credible path of an Italian exit from the euro on a 2-3 year view. Consequently, we believe that many are unduly bearish on Italian prospects.
From a political perspective, we continue to believe that the core constituency of La Lega in the wealthy regions in the north of Italy has no desire to pursue a Eurosceptic agenda. Indeed, recent woes in the party and its own internal finances, means that Matteo Salvini and others are unlikely to want to upset their donors in the business community – even if they wanted to do so; which it seems they do not. Rather, we expect immigration to provide the overriding focus of the party as it eyes a possible election in 2019, though with the summer passing and temperatures in the Mediterranean cooling, this should lead to fewer migrant boats making the hazardous journey from North Africa in the months to come.
Brexit time bomb
Meanwhile, in the UK, it appears that next to no progress is being made on Brexit negotiations, despite all of the comments and rumours and general huffing and puffing coming out of Westminster. We believe the next significant event could be the Labour Party conference, at which we see a good chance that a 2nd Referendum will be adopted as a Shadow Government policy. As an aside, it seems interesting to think that it is currently the Labour Unions in the UK who seem to be holding the interests of businesses (and workers) closest to heart.
The Conservative Party conference also promises to be full of intrigue, rancour and spitefulness, yet little of substance may be expected from this particular gathering. While all of this goes on, the clock continues to tick down and it appears in the rest of the EU hopes are growing that the whole Brexit process may yet be stopped, meaning that there is little incentive for Brussels to show much flexibility in their position.
Tantrum and tears
Looking ahead, we would observe that if US yields continue to move upwards, then this is likely to favour the dollar and could serve to re-ignite stress in EM and this keeps us relatively cautious for the time being. More recently, we have had more conviction with respect to our bullish call on the euro periphery, where we continue to see value in Italy and Greece. It seems that for all of the hysterics, Italian policy makers are being relatively well behaved in the broader scheme of things and perhaps volatility in BTPs earlier in the summer serves as a helpful reminder that they would be foolish to risk financial stability at a time when spending an extra EUR5 billion in the budget could end up costing the country an extra EUR25 billion in additional interest rate expenses.
It seems that restraint is the order of the day and it would appear that the hair pulling, tantrums and tears are left to the Italian football players (or one particular Juve superstar) instead.