At the end of last week, the market began to breathe again. All of the risks so hotly discussed over the past few weeks have come to seem rather distant with investors heavily buying Italian sovereigns and starting to grow more comfortable with emerging markets. With President Trump preparing to implement $260 billion worth of tariffs against China, however, it is evident that this is just the calm before the storm.
All remains at stake. The problems with Argentina and Turkey have not yet been resolved. This week might be key for EM as the International Monetary Fund could give its response regarding favourable funding for the Latin American countries, while on Thursday all the eyes will be on the Turkish central Bank which investors hope will announce a more comprehensive policy response to the current crisis.
Uncertainty is one side of the coin, but EMs real problems of a strong dollar and rising rates are real and will continue to provide headwinds. While EM have benefitted from loose monetary policies for more than a decade now, and investor tolerance and appetite for riskier assets has expanded, things are changing.
With interest rates are rising at home, money will repatriate to the US. While it is normal to expect this behavior at the end of an economic cycle, however, the selloff will be more pronounced if investors perceive a structural weakness within EM.
This is exactly what is happening now.
A troubled Italian calm
After a weekend on the shores of Lake Como and a long high-carb lunch, Italians are seemingly buddy-buddy with the European Union once again. Flat tax campaigner and anti-immigration firebrand Salvini is now saying that he is more worried about the market than his own children.
It is possible, we suppose, that the Italian interior minister has changed his mind. Maybe he thinks that he does not need that much more debt to achieve the expensive policies promised to voters by the Lega/Five Star coalition. Other politicians, however, are unlikely to feel the same way.
It is certainly good that Italian politicians are recognising that they prefer a stable market to a volatile one, but the coalition’s overall message remains dismissive of the EU. Until the budget for 2019 is unveiled, there is no certainty as to what is going to happen.
We remain underweight Italy as we believe that BTPs remain extremely vulnerable to news. A better picture will be drawn by mid-October after Rome presents its 2019 budget to the EU and has discussed this with its European counterparts.
Flat yield curve puts pressure on US high-yield corporates
Within fixed income, the US high-yield space is the only one that has returned profits year-to-date. But how much more value can investors find within this space?
To answer this question we need to look at the evolution of the yield curve. The chart below shows the yields of two-, 10-, and 30-year Treasuries. As you can see, two-year yields are rising faster than the longer part of the curve, and now they trade at a 10-year high of 2.72%. As the short part of the curve rises, more pressure will be applied to high-yield corporates, making refinancing more and more problematic.
Valuations in this space appear too high and although demand for these bonds is supported by a positive backdrop, I can see that this is quickly becoming a bubble destined to reprice as financing conditions worsen.