Huge Day For The Political Headlines
Tuesday wasn’t a great day for investors who are only focused on the fundamentals of the American economy and earnings as political risk was the star of the show as 3 major news events occurred today which affected the markets. First, the Italian President rejected the economic minister proposed by the right wing parties bringing about modest worries of contagion risk. Second, the Vice Chairman of North Korea will be meeting Secretary of State Mike Pompeo. A few hours after this was announced on Tuesday morning, it was confirmed that the summit with North Korea and America on June 12th will occur. The third event was the Trump administration announced plans to go ahead with the trade actions against China to limit the country’s theft of American technology firms’ intellectual property. I will be reviewing the most important of these events, which was the Italian political event, in this article. I’ll review the others in future articles.
Review Of Tuesday’s Trading Action
Before I review the specifics of the Italian news, let’s review the effects on the American markets because they were severe in some areas. The S&P 500 was down slightly in early trading even though the market already had knowledge of the Italian political situation. Around the time of the announcement that the North Korean official would meet with Pompeo in New York City, the stock market sold off further as the Dow was down over 500 points at the low of the day. There was a small rally in the last half hour of trading as the S&P 500 closed down 1.16% and the Dow fell 392 points which is 1.58%.
The Nasdaq was only down 0.5% as its possible tech stocks were helped by Trump’s tariff actions against China to protect intellectual property. The tech sector in the S&P 500 was down only 0.66%. The Russell 2000 was only down 0.2%; the market fell because of geopolitical issues, so domestic small caps outperformed. The decline in rates caused the financials to decline 3.37%. Morgan Stanley was the worst performer of the group in the S&P 500 as it fell 5.8%.
The decline in yields was massive. The 10 year treasury yield fell 15 basis points to 2.78%. It’s now down 33 basis points from May 17th. Even though American growth looks strong compared to other advanced economies, the risk of contagion in Europe has caused investors to flood into the treasury market. I mentioned that American outperformance could cause investors to move to U.S. stocks, but the ‘risk off’ nature of the capital flow pushes it to treasuries. The 30 year treasury yield fell about 12 basis points to 2.97%. This is the first close below 3% since April 11th. With the 10 year yield falling more than the 30 year yield, that part of the curve steepened.
The 2 year yield fell about 15 basis points to 2.32%. The Fed’s dovishness started off this decline in short term yields, but now the market is pricing in fewer rate hikes because of the European political risk. Dovishness is good news for stocks, but a peak in the 2 year yield signals the business cycle is close to ending. The latest difference between the 10 year and 2 year yields is 46 basis points. In pre-market action the difference fell to 42 basis points, but after investors priced in a much more dovish Fed, the curve steepened.
Italian Political Risk
The Italian news was President Sergio Matterella refused to accept right wing economist Paolo Savona to head the economy ministry. This situation isn’t a complete surprise because the right wing League and 5 Star Movement’s recent coalition has dramatic differences with the technocratic establishment President. This caused the 5 Star’s leader to call for Sergio to be impeached which is quite historic even for Italy as the government was just formed. Italy could be headed for another election in September which probably will give the right wing parties even more control because the Italian economy continues to be in shambles. GDP growth per capital hasn’t increased in 18 years, so there’s a large cohort of disgruntled Italians.
The worst case scenario for the E.U. is playing out. The 5 Star Movement and League have pulled back from calling for the end of the E.U. This is because it could lead to short term economic pain and because the parties are trying to broaden their appeal. If the establishment Democrats allowed the right wing parties to pursue their agenda, there wouldn’t have been an ‘Italeave’ scare Tuesday. However, because Matterella isn’t allowing them to pick an economy ministry head, they are going to use this to build momentum and anger focused on the establishment. The last thing an establishment party can do is deny populism representation because it causes populism to spread further as the populist leaders claim the situation isn’t fair.
Now that I reviewed how we’ve gotten to this point, let’s go over the current quandary which caused Italian yields to spike and the default probability to increase as you can see from the chart below. The ECB can buy more Italian bonds to quell the situation, but the problem is it will likely require fiscal reform in return for helping the country which the right wing populist parties won’t agree to. The populist movement was created because of this anti-democratic situation where E.U. leaders influence Italian policy. The last thing League and 5 Star will want to do is make a deal with the E.U. If the ECB doesn’t step in to prevent the bond vigilantes from taking control of the government bond market, the Italian economy will worsen. That will give the populists fodder to renew calls for Italy to leave the E.U.
Conclusion
Even though it seems like this is a new event which came out of the blue if you only focus on America, this has actually been in the works for a while. The Italian economy provides little opportunity for the youth which has caused political unrest which can’t be bandaged over. This problem won’t go away. That doesn’t necessarily mean that America will enter a recession and a bear market. By pushing down yields, delaying rate hikes, and pushing down commodity prices, it might cause a correction and extend the business cycle like what happened as a result of the Greek crisis in 2011-2012.
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