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Volatility in Markets Derives from Uncertainty

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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