By Mark Bern, CFA
The formation of a new government in Italy has everyone
guessing, especially those within the Eurozone (EZ). The two parties that gained the most seats in
Parliament represent two very different factions but both are euro sceptics in
that they have no love for those calling the shots in Brussels. There is a lot of uncertainty about Italy at
the moment and, by extension, the future of the EZ.
The spread between the German and Italian 10-year bonds
widened to 2.9% at one point this week but narrowed back to 2.3% by
Friday. In April that spread was a mere
1.1%. That is a relatively large move in
such a short time for a 10-year bond yield.
What it means is that there is much uncertainty surrounding the
political direction of the next Italian government. Until that is settled, uncertainty could lead
to further volatility.
According to polls many Italian people blame Brussels for
the austerity measured that were foisted upon them during the last European
crisis. Results of the recent elections
bare witness to those findings. It will
be interesting to see how power is shared by the leading parties and what
concessions each will need to make in order to form a new coalition. Until then the concerns will continue.
In the U.S. we are watching the “real” yield on the U.S.
10-yr treasury bonds, which is the nominal yield less inflation. In mid-May the real yield got as high as
0.92%, a post financial crisis high, but again by Friday had retreated to
0.80%. The later real yield is within
the range that has dominated since 2010.
A higher real yield would indicate that higher inflation is
expected. When inflation expectations
rise stocks usually become more volatile (generally meaning a pull back or
correction).
If the real yield increases too much it can mean slower real
growth is anticipated. Unfortunately, if
such a reading persists, business leaders tend to prepare for what may be
coming which, in turn, often creates the reality that is expected.
It is similar to the boy who came home from college with his
business degree and told his father that economists were expecting a
recession. The father ran a thriving
stand selling fresh produce. The son
explained that when the recession hits the buyers would not come in such great
numbers and the much of the produce would rot.
In order to keep spoilage under control and control costs the son told
the father to start reducing his inventory.
The father put a lot of faith in his son’s advice because he
had paid a dear price for the college education obtained by his son. So, the father began to purchase less fresh
fruits and vegetables each week to control his costs. By the middle of each week his stand had been
picked over and many regular customers purchased less than in the past.
By the third week fewer people showed up, especially after
mid-week, and the father had to start discounting the remaining produce to sell
what was left. Another two weeks later
traffic had fallen to a trickle and sales were only a fraction of what he had
experienced before he began preparing for the coming recession. He order less and less, yet more and more of
his produce spoiled.
In the end, the father had to close down his produce stand
and find a job. The economy never did
fall into recession but the son’s prophecies had come true nonetheless. The father never understood what went wrong.
The moral of that story is either “wait until you see the
whites of their eyes before you fire” or “be careful what you wish for.” In any case, we can create a recession when
one is not imminent if we just believe strongly enough that one is coming.
On another front the fear gauge of a world trade war rose
again last week as the President decided to enact tariffs on steel and aluminum
from Europe and Canada and ordered a review of car and auto parts imports. The negotiations with China were off and then
on again and the same happened with North Korea, but about a completely
different matter. Still, the U.S.
president is keeping everyone up at night with his tweets and negotiating
tactics. Our allies preferred a much
more controlled negotiating environment.
These new tactics have everyone uncomfortable. With that comes uncertainty and volatility in
the markets
Fortunately, the trade war sirens had waned and fallen
almost silent by week’s end so stock rallied once again. None of us should be complacent but neither
should we begin to take steps to prepare for the next recession just yet. The signs are very mixed but I still believe
that the tailwinds pushing earnings higher throughout the remainder of this
year will win out unless a real trade war takes hold.
Negotiations will take longer than desired but there is too
much at stake not to find solutions that all parties can live with, at least
until the next presidential election. My
guess is that, even though most nations want permanent trade agreements, more
will come to the reasonable conclusion that deals with sunset clauses requiring
renegotiation to occur sometime after the next election (or maybe the next two
election, just to be sure) may be the best solution; give up that which is
necessary to avoid a trade war in the short term and hope to get a better deal
with the next occupant of the oval office.
Until then sanity should return and quality, well managed
companies stocks should continue to rise for at least the rest of 2018.
Respectfully,
Mark Bern, CFA
Bern Factor LLC
mark@bernfactor.com
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