US equities have started the year in an amazingly tranquil way. Under such calm, the Dow and S&P500 have reached record levels.
2016 saw a number of pivotal moments, including; Brexit, the election of Donald Trump, huge flows of immigrants into Europe, and a surge in extremist political factions. The repercussions of these significant events and themes will affect markets during 2017.
European government bond yields have risen markedly since the beginning of fall 2016. But "this time, it's different," or at least it should be. Indeed, the landscape of the eurozone economy has dramatically changed since the 2010-2012 sovereign debt crisis.
Having enjoyed an extended Christmas rally all the way through January and now into the second week of February, there are a few clouds appearing on the horizon that have caused us to take stock and start booking some early profits, while the technical position remains strong and liquidity remains available.
So what is worrying us?
Quite simply it is politics, on a variety of levels, and despite there being nothing imminent to derail markets, we think there is a lot of complacency amongst market participants assuming that everything will work out just fine.
- In the US we have Trump, and the broad reaction is that he is good for growth, good for credit and bearish for rates. Well a lot of this is now priced in, and we are not leaving much room for policy error or execution risk.
- In Europe we have a variety of elections in 2017, but the one that stands out is in France where we have the first round of the Presidential election on 23rd April followed by the deciding second round on 7th May. Polls tell us that the right wing Marine Le Pen will make it into the final round, but will fall at the last hurdle, but can we believe polls anymore? Having heard a few more of her economic plans at the weekend, we are acutely aware of the downside of a Front National victory, with policies such as currency redenomination already being promised.
- Additionally, we have the real possibility of early elections in Italy where the vote could be even closer, with similar threats of downside issues hanging around Italy’s membership of the Euro should the anti-establishment vote succeed. This was well flagged in the December constitutional referendum, but markets were willing to overlook this in favour of the Trump rally. How long will this persist?
Already we have seen significant spread widening between both French and Italian sovereign debt relative to the German counterparts. France is nearly 70 basis points wider than Germany since the end of September and Italy is wider by nearly 100 basis points over the same period. These are material losses, given that each basis point is worth nearly 10 cents and the yields are so low. Additionally, in recent days we have seen spread widening in French banks as the contagion slowly seeps into the banking system. Heard this all before? Of course, and we can all remember how severe the worries were in the past. However, each time we have recovered, but only after some mark to market losses first.
Now we could be worrying about nothing but while bonds are such lofty levels following the recent rally we think it makes perfect sense to take some ‘chips off the table’ so that we can reinvest at better levels if market volatility picks up, as we suspect it might. There is every chance that we might be early on this move but sentiment can change very quickly and currently liquidity remains strong, enabling us to execute efficiently. In the meantime we can be slightly more relaxed watching the French politicians shooting themselves in the foot and opening the door to Marine Le Pen.
Mark Holman - CEO - TwentyFour AM