The Days Ahead: Quieter week for big economic numbers. Watch for trade and updates on the Eurozone.
One-Minute Summary. When markets crack, we know two things. One, the problems don't come from the last crisis (so no need to look in the MBS world). Two, they come from things you barely notice. Last week it was Argentina and Turkey. This week, it was Italy (see below). U.S. bonds promptly rallied 4.5% and the 10-Year Treasury yields, which many predicted would soar to 3% and beyond, fell to an intra-day low of 2.79%. Bonds got medieval on Tuesday and one Bond King had a very bad day.
Domestic and international stocks and U.S. bonds finished more or less unchanged on the week. But there was plenty of action along the way. Small caps had another good week (they tend to not get riled by trade stuff) and are now some 500bps ahead of the large caps so far this year.
The trade talk is not good. The U.S. went ahead with tariffs on steel from Canada, Mexico and the EU. We don't think they're going to take this one lying down. In past years, the parties would have taken the issues to the WTO and talked about it for a couple of years. This time Cecilia Malmstrom, the very accomplished EU Trade commissioner fired right back with, “When they say American (sic) first, we say Europe united.” So far markets have tended to view the trade talks as bluff followed by climb down. That’s worked. So far. Still, expect a lot more disconcerting headlines.
1. Markets are jumpy (Part 2): Here’s something you don't see very often. A G7 sovereign bond crashing in a single morning’s trade. As everyone knows by now, Italy is trying to form a government on a coalition of two parties. The Northern League (secession, pro-Russia, anti-GMO, lower taxes, Eurosceptic) and the 5-Star Movement (guaranteed minimum income, Green, unsure about immigration and mostly Eurosceptic) tried, failed and tried again to form a government. In Italy, winning parties must present their cabinet and government candidates to the President. He has veto power. And he used it. The fear then was another election in the fall with both parties running on an explicit “out-of-Euro” platform because…that’s the only thing these guys really agree on.
Now we've seen Italian governments come and go and, with 42 Prime Ministers since 1945, a change of government in Italy passes as a Cabinet reshuffle elsewhere. And we don't really think this time is different. A government will form, it will make a few changes and it will argue with the EU about debt, growth and bond restructuring.
So why did this happen?
That spike on the right is the spread between Italian (BTP) and German bonds (Bunds). Both Euro sovereigns. Both have never defaulted in 70 years. Both with rapidly improving current account surpluses. But the spreads “blew out” (technical term) from 120bp to 270bp which meant the price of an Italian bond dropped from €102 to €89. Stocks took a smaller hit and investors dumped Italian banks, who, of course, must hold BTPs for capital. Some of the big-name stocks were down some 25% from their late-April peak.
By week’s end, things had settled down. The 5-Star and League parties will get their people in. The problems from the Berlusconi years (see famous Economist cover) will remain. Italy’s GDP per capita hasn't risen in 20 years. It seems unlikely a rancorous split from the EU will achieve much. And markets probably don't expect Italy to take it that far.
We don't own foreign bonds and this week was a good reason why. You can lose much more of your principal on a spread-widening event than you can on rising rates. To us, fixed income allocations should reduce the risk of a portfolio, not increase it. But expect this to play for a while.
The headline unemployment number is now at a 20-year low. Last time it was this low, the 10-Year Treasury was 6.5%. So why is it only 2.8% now? And didn't even move on the day? Sure, some is because of the Fed’s QE and low inflation. But we think the market is not wholly convinced about this labor market. We've touched on some of these in the past but here goes:
- The uninsured part of the labor force is the lowest it’s ever been. If you're not insured to receive benefits, you don't register for them.
- Wage inflation is barely moving in nominal terms and flat in real terms.
- Quit rates have not reached their pre-crisis level. You tend to quit a job if you're sure you can get another, so it's a confidence thing.
- The U-6 (underemployed) rate is nowhere near a 20-year low.
- Participation in key age cohorts is way down.
To which, critics respond, well the labor market has changed, if you want a job you can get one and look this week’s Beige Book says St Louis is even hiring convicted felons. So, it's a tight labor market.
Fair enough, but nearly six months into the stimulus we’ve yet to see big consumer spending numbers, even though people are paying a little less tax (in aggregate, not in California). As one of the best analysts put it, “the longer the stimulative benefits of those particular policy changes [tax cuts] take to show up, the less likely it is that they will.”
Bottom Line: The Spain and Italy markets support our belief that U.S. Treasuries will remain well-bid and the 2-Year Treasury looks attractive above 2.5%. U.S. economic numbers last week were good but seemed more to be catching up with a run of less-than-great reports.
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Something for the weekend