- Michael Livian, CFA and Martin Fridson, CFA
All Roads Lead to Rome ...
May was quite a strong month for US stocks. The US indices outpaced foreign stocks, driven by a rebound in the information technology and industrial sectors. Consumer staples and defensive sectors continued to trail on the year. Growth outperformed Value/dividend-oriented stocks.
The US currency strengthened, penalizing Emerging Market stocks and bonds, especially from those countries with large foreign currency debt balances. At the same time, crude oil weakened after a very strong run year-to-date. Bond yields were stable, with the 10 year US Treasury yields closing at 2.85% after a brief visit above 3.1%.
The strength in the US markets is imputed to improved expectations for Q2 US GDP growth and positive earning revisions by analysts. The employment numbers speak to the health of the US economy:
In a recent interview, Jamie Dimon, the CEO of JPMorgan Chase, said that we are probably in the "sixth inning" of the economic recovery and that a renewed "growth acceleration" may be in the cards.
Two issues may spoil the party: 1) the rising trade tensions 2) the flare-up in the Italian debt markets.
Rising Trade Tensions
Investors aren’t the only ones riled by the administration's announcement it would impose hefty trade tariffs on American allies. “Brussels’ top trade official vowed to respond to Donald Trump’s new tariffs on imports of steel and aluminum from the EU, Canada, and Mexico with measures of its own, and warned that the EU has closed the door on trade talks with the U.S.”
The trade spats with the EU and China, if turned into a trade war, are likely to translate into slower global GDP growth and higher inflation. At this point, it is impossible to tell the facts from the rhetoric, but vigilance is warranted.
The Italian Saga
Italy holds many records, among them the number of governments voted into office during its post-war's short republican history and the amount of its public debt. To be more precise, the Italian government debt is the third largest in the world (around $2.7 trillion, behind only the US and Japan) and among the highest as a percentage of GDP (132% of GDP) of any developed country. From 2000 to 2016 Italy was one of the few countries in the world to experience a per-capita GDP contraction.
On March 4, 2018, a general election was held in Italy. The results were largely inconclusive. No political party obtained enough votes to achieve a parliamentary majority. Two fringe anti-establishment groups won the highest percentage of the votes: the Five Star Movement, a web-based anti-immigrant and anti-Europe movement started by a comedian (Beppe Grillo), and the League, a right wing political party formerly advocating Italy's northern regions secession.
These two group recently formed a government lead by Giuseppe Conte, after a number of mishaps. The financial markets reacted very negatively to this development. As late as May 15, 2018 the 2-year Italian Government bond yields were negative, on May 28 they were above 2.7%. The very sharp increase in Italian yields coincided with a remarkable decline in German and US government bond yields, -0.4%. The anti-european credentials of the new Italian executive branch are rekindling the fears of a disorderly exit of some countries from the Euro.
Giuseppe Conte is Italy’s new Prime Minister. He has a tough job ahead. Despite electing “…western Europe’s first anti-establishment government bent on overhauling European Union rules on budgets and immigration,” Italians aren’t keen on leaving the euro behind. Last week, “…opinion polls…showed between 60 and 72 percent of Italians did not want to abandon the euro,” reported Reuters.
The US economy and corporations are doing well and our main indicators (leading economic indicators, yield curve, credit conditions and market technicals) remain supportive for risky assets. An external shock may cause this scenario to change. The Italian debt problem is one of the main risks overhanging the global financial system. We believe that the likelihood of a Euro break-up and/or Italian default is very limited, but worth observing closely.