“You never bet on the end of the world, that only happens once, and the odds of something that happens once in an eternity are pretty long.” – Art Cashin
“A thing long expected takes the form of the unexpected when at last it comes.” – Mark Twain
This week’s piece is a follow up to last week’s Contrarian Quartet (Part I). We outline the remaining two out of the four opportunities where we find the risk-to-return profile in being contrarian is far more attractive than in following the herd.
Rather fortuitously we decided to delay writing about Italy, the first of the two opportunities we discuss below, to this week as the deterioration in sentiment towards the sustainability of the European Union has accelerated.
“In investing, what is comfortable is rarely profitable.” – Robert Arnott, chairman and chief executive officer of Research Affiliates
As recently as three weeks ago, investors were disregarding the risks of political turmoil in Italy and lifting the Italian stock market higher. From the start of the year to market close on 7 May, 2018, the FTSE MIB Index generated a total return of 12.2 per cent in US dollar terms versus a measly return of 41 basis points for the MSCI All Cap World Index. Starting 8 May Italian outperformance started to unwind and the year-to-date return for the market, based on live prices as at the time of writing, is now negative. As the cliché goes, stocks take an escalator up and an elevator down.
FTSE MIB IndexSource: Bloomberg
Investors were first spooked by the two leading populist parties in Italy – the Five Star Movement and the League – moving to form a coalition to run the country. And then by President Sergio Mattarella’s decision to block the formation of a eurosceptic government and selecting Carlo Cottarelli, an International Monetary Fund alumnus, as prime minister-designate, to try to form a new government.
The selection of Mr Cottarelli, who has consistently defended Italy’s membership in the euro and became known as “Mr Scissors” for making cuts to public spending in Italy during Enrico Letta’s brief period as prime minister, has antagonised the populist coalition. The populists see the selection as a deliberate attempt by President Mattarella to undermine the Italian people’s will as expressed by them in the recent election. Moreover, choosing Mr Cottarelli flies in the face of the coalition’s desire to put eurosceptics in key cabinet positions – as they tried to do by choosing Paolo Savona, the 81-year-old Eurosceptic economist, as their economy minister.
Given the antagonist nature of the President’s selection, Mr Cottarelli is highly unlikely to win a vote of confidence in parliament. Italy, in all likelihood, will have to hold a new set of elections in the autumn. And the next election has inextricably become about Italy’s membership in the euro. The worry is that the populists will use the bitterness from President Mattarella’s actions to rally their voters and emerge even stronger after the new elections.
Investors have been selling-off all things Italy in apprehension. Most drastically, the yield spreads between Italian and German government debt has blown out.
Italian vs. German 10 Year Government Bond Yield SpreadSource: Bloomberg
This is not the reaction President Mattarella was expecting, we suspect.
While we acknowledge that political risk in Europe is back in vogue, we consider the probability of an Italian exit to be low and with the caveat that Señor Draghi keeps the monetary spigots up and running we see even less risk of financial contagion spreading through Europe.
Consider the state of Italian sovereign debt today versus that at the height of the Euro Crisis. Foreign-ownership of Italian sovereign debt is down from 41 per cent in 2010 to 32 per cent today, with non-European investors holding a paltry 5 per cent. At the same time, Italy’s debt servicing costs as a percentage of GDP are at their lowest level since the euro was instituted – this of course is largely down to the ECB’s benevolence.
The Italian economy has been humming along quite nicely with first quarter GDP year-over-year growth of 1.4 per cent. Italy is also running a primary fiscal surplus and the fiscal deficit for 2017 was just 2.3 per cent of GDP and is likely to fall below 2.0 per cent in 2018.
The possibility of a fiscal blow-out due to extortionate spending by the populist coalition, if it is elected in the next elections, is also highly improbable. Since 2012, the Italian constitution mandates the balanced budget law and the president has the power to veto any decision that is not in adherence with this law. We are almost certain that a Europhile like President Mattarella will not hesitate in exercising the veto should the need arise.
Lastly, there are clear ideological differences between the two coalition parties and it is likely that such differences will be severely tested in the run up to the elections and, if they are elected, by the highly bureaucratic legislative system in Italy. We suspect that the differing ideologies will impair the populist coalition’s ability to implement policies, which in turn will severely test its survival.
For these reasons we consider the drastic widening of the yield spread in Italian debt relative to German debt to be somewhat unwarranted. Despite this and given where absolute yields are in Europe, we do not think investors should have any sovereign or corporate bond exposure in Europe.
We also think it might still be a bit early to add broad based exposure to Italian stocks. Although selectively we are starting to see opportunities in high quality Italian companies, which we will be monitoring closely for potential entry points.
Where we see the greatest opportunity is to go long the euro relative to the US dollar. We think the current sell-off in the euro is sowing the seeds for the next down leg in the US dollar. The political uncertainty has facilitated the unwinding of bullish euro and bearish US dollar positioning. We suspect positioning will quickly become, if it has not already, very bearish in the euro and bullish in the US dollar. Overly bearish positioning is in our minds a necessary condition for the euro to re-assert its bullish trend.
US Long Dated Treasuries
GS US Financial Conditions Index versus US 30 Year Treasury YieldsSource: Bloomberg
In The Convergence of US and Chinese Bond Markets we wrote:
“The shifting secular trend does not, however, warrant shorting US treasuries. The last secular US bond bear market lasted thirty-five years and can be sub-divided into thirteen parts: seven major price declines and six bear market rallies. Moreover, even though short-term interest rates bottomed around 1941, long-term bond yields continued to decline till 1946. We would not be overly surprised if a similar dynamic played out once again, with short-term rates bottoming in 2015 and long-term bond yields bottoming several years after.”
While we remain secular bears on US government bonds, we think long dated US treasuries currently offer a tactical opportunity on the long-side. US financial conditions have started to tighten after the easing induced by the enactment of the Trump tax plan – for instance US companies pre-funded their pension schemes to benefit from the higher tax rate in 2017 and contributed to the easing in financial conditions – is beginning to wear off and the reality of higher rates and higher oil prices squeezes system-wide liquidity. As demonstrated in the above chart, as financial conditions tighten, long-term bond yields tend to decline shortly after. Add to this the near record levels of short positioning in long-dated treasuries by non-commercials and you have a recipe for sharp rally in long-dated US treasuries.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein