Monthly Commentary May 2018
Are we seeing Quitaly? Not that it matters.
The second half of May was dominated by headlines on the formation of a populist government in Italy (by the Italian President Mattarella over the choice of finance minister, but back on track at the time of writing). Que the “volatility” of a flight to safety (gilts, core euro govies and US Treasuries) and some excitable equity markets.
But equity markets still ended May rather well. The UK equity market reached new high ground during the month whilst US markets also performed strongly. The rise had many contributing factors, from strong labour market data in the UK, and on the back of several actions by the US. The first of these originated from higher oil and other commodity prices (caused largely by President Trump walking the US out of the Iran nuclear deal), then by US Treasury Secretary Mnuchin dialing back the tariff trade war rhetoric with China after China agreed to buy $200bn of US goods, and finally by softened market expectations on the pace of future rate rises in the US and UK following lower than expected inflation data in the US. UK pension funds by this point have long diversified their equity exposure globally, but on average still maintain an overweight to the UK relative to the market capitalisation weight. Combined with the allocations to the US, and the resulting underweight to Europe, they have every reason to be – for the moment at least – sanguine about events in Italy (and Spain’s latest political drama with Rajoy) and their impact upon their portfolios.
“For now, our most likely scenario is that further escalation isunlikely and that Italy will not leave the EU nor the euro.”Nikesh Patel, Head of Investment strategy
So not that it matters, but it is interesting. Briefly then, it is our view that the uncertainty surrounding the sustainability of Italian debt is (this time) ill-timed due to the planned reduction of QE by the ECB. The ECB (actually the euroSystem) currently owns around 20% of Italian debt. For now, our most likely scenario is that further escalation is unlikely and that Italy will not leave the EU nor the euro. Recent surveys in Italy point towards only limited support for these drastic measures. We therefore do not expect the political parties to aggressively pursue this during their campaigns for the next elections. Interesting too is the coalition itself: Lega and M5S should at first glance be an impossible alliance. As our Chief Strategist, Roelof Salomons, points out, Lega had favoured a segregation of the south for a long time, as the people were said to live off the money that was made by hard-working northerners. The Five-star Movement, on the other hand, got a lot of voters from the south. Apparently, my enemy’s enemy is my friend. Undoubtedly their ‘strategy’ of increasing spending without raising income leaves the domestic financial situation in Italy at risk. However as the majority of government debt is held by Italian financials (banks and insurers) and the ECB, rather than UK pension schemes, our considered view is that trustees should – as they did through the various election non-events in 2017 – stay their courses.
The old adage is to sell in May and go away (buy again on St Leger Day). That would, in our view, be an overreaction to current market volatility, and in the context of the exposure a well managed scheme is likely to have to the risk of populism. We will be issuing a gem of thinking around the causes and impact of recent populism, and the likely progression (and political reaction) of populism in the coming weeks – please do keep watch for it`.
The Italian Job
There was a great deal of noise in May with Italian elections, trade wars and talks with North Korea. The headline event, however, was undoubtedly the market’s reaction to the chaotic scenes in Italian politics. Such scenes are hardly new in Italian politics but this particular round of chaos seemed to provoke a significant, if short lived, reaction. The main area of contention was the appointment of an explicitly euro-sceptic finance minister who was subsequently vetoed by the Italian president, bringing with it the threat of fresh elections which could turn into a proxy referendum on the euro. In the end, the crisis was averted by the appointment of an alternative finance minister.
I suspect however that the moment of reckoning has merely been delayed rather than cancelled (though readers who travel with Thameslink may well argue that there is very little difference). The unstable coalition, consisting of the populist M5S and hard right Lega, are still seemingly intent on cutting taxes, raising spending, increasing borrowing and thereby causing a confrontation with the European Union. However. as my colleague Nikesh Patel argues in his monthly commentary, the direct impact on UK pensions schemes of such a confrontation is likely to be limited.
Of more long-term interest to UK pension investors is the state of the UK economy, not necessarily due to their holdings of UK equities, most of which have now been diversified away, but because of the influence of UK interest rates on liability valuations and some specific exposure to the UK credit market. As mentioned in last month’s commentary and ahead of the May Inflation Report, Mark Carney once again did his best impression of an unreliable boyfriend leaving yet another potential rate rise hanging around, checking its watch before trudging back home feeling unwanted.
Immediately following the release of the Inflation Report short dated yields fell by 0.04%, although they had fallen more significantly in the weeks running up to publication. However, there was some cause for optimism amongst those expecting policy rates to rise in this year.
“The MPC continued to judge that there was very little spare capacity in the economy as evidenced by the continued low rate of unemployment. ”Robert Scammell, Senior Portfolio Manager
The MPC continued to judge that there was very little spare capacity in the economy as evidenced by the continued low rate of unemployment. Whilst this is yet to feed through into the kind of wage increases that could be expected, given such a low level of unemployment the direction of travel is positive. Wages have now risen consistently since mid-2017. Whilst growth in demand is anticipated to be modest by historical standards it is expected to grow by more than capacity for supply which will continue to be constrained by low productivity. Combining the supply and demand side, the MPC believe that that there are ‘’continuing signs that domestic inflationary pressures are building gradually.”
At the time the inflation report was written markets were expecting three rate rises over the next two to three years, sufficient to hit the inflation target of 2% p.a.(see chart.) Crucially this forecast was based on a 15-day moving average ending on the 2nd May, a period when short term interest rates were 0.16% higher than they were by the end of May. Since then the data has been slightly more positive and oil prices in sterling terms have continued their relentless rise upwards. Like the Italian confrontation with the EU, it seems possible that a rate rise has merely been postponed rather than cancelled.
For UK pension funds a small increase in the UK policy rate may not make an immediate difference to the longer dated yields that impact their liability valuation. However, long-term rates are to a greater or lesser extent determined by short-term rates and any increase should therefore be welcomed by pension schemes.