28th May 2018

Batten down the hatches – again!

MARKET CLOSE:
iTraxx Main

65.2bp, +2.6bp

iTraxx X-Over

298.6bp, +12.2bp

🇩🇪 10 Yr Bund

0.35%, -6bp

iBoxx Corp IG

B+124bp, +4bp

iBoxx Corp HY

B+371bp, +13bp

🇺🇸 10 Yr US T-Bond

2.93%, unchanged

🇬🇧 FTSE 100 , 🇩🇪 DAX , 🇺🇸 S&P 500 ,

Politics sink markets…

It’s starting to look like a May to forget. Rate market investors have been fortunate enough to come out on top into the re-emergence of macro and geopolitical event risk, after what was a fairly brighter opening week. The supposed economic plan of a new governing coalition being cobbled together in Italy had been a real poke in the eye for risk markets, and Moody’s had already reacted by putting the BAA2 rating on review for downgrade.

However, news that the Italian PM-designate had given up his mandate to form a populist government after the country’s President rejected his nomination for a euro-sceptic economy minister will have stirred some more. The markets didn’t like it one bit. And news of a stop-gap candidate and technocratic cabinet doesn’t solve the problems.

Italian politics in a nutshell: A mess.

Almost 70 governments since the second world war. The President has a disproportionate amount of power, in our view, needing to agree to the coalition’s choice of ministers. Right now, he has decided to reject the coalition’s choice of a euro-sceptic economy minister and has installed his own choice of PM who will lead a technocratic government – until new elections can be arranged (September/October), as parliamentary support and confidence will unlikely be forthcoming.

That means it’s back to the drawing board. Another election either gives a more (likely) decisive victory to the populists, meaning that the President will be close to welding an unconstitutionally disproportionate amount of power and need to yield – should he subsequently maintain his current stance. Or, more disarray and no decisive outcome (much like the current one).

And as if we needed anything else to worry about, we have the potential for an election in Spain as a vote of no confidence in the current government is being called for by opposition parties following a corruption case involving the ruling Popular Party. That vote is slated for Friday.

Either way, Italian debt markets are now going to remain under pressure. We might have got a small bounce at the open on Monday, but it didn’t take long before markets realised that it’s still all an unholy mess. The 10-year BTP yield, using as the standard benchmark, dropped to 2.36% (-9bp) before rising sharp and hard intraday to 2.70% (+25bp) and the equity market in Italy closed 2.1% lower, dragging other European bourses lower too following that brighter open by around 0.6%.

For once, the bad news isn’t quite raining down on us. We could have been adding to those geopolitical woes when looking at the US/North Korean spat. We were up until last Friday! But now we have good news coming as a result of the reversal in Trump’s decision to bail on the proposed meeting with the North Koreans. Unfortunately, the situation is extremely fluid, and we are just a ‘bad hair day’ (read Trump Tweet) away from the whole thing being called off – again. For now, though, it looks surprisingly and refreshingly upbeat on this front.

With Italy and Spain being the chief protagonists in the Eurozone, it takes us back to the crisis days in 2010-2012. Unfortunately, both of these situations look like being slow-burning fuses. Spain, though, does not hold the same existential threats to the Eurozone as might Italy, we would think – the problem there being of a more internal/domestic flavour.

But it is all coming against the backdrop of slowing growth across the Eurozone. Which means from a market perspective, it’s back to being defensive. Look for the lower growth dynamic to persist, investment isn’t going to pick-up, business and consumer confidence will stay under pressure, and the ECB will be compelled not to change anything for the moment.

Caution reigns. There’s a bit of a bunker mentality prevailing in the markets although equities are failing to be over perturbed by it all (Italy aside). Safe-havens are in the ascendancy. It’s been a while since the 10-year Bund yield was last through 0.40% – but it has dropped to 0.35% (-5bp, Monday). Or the Gilt yield down at 1.32% (-8bp, Friday’s close). Even the 5-year Bund yield has fallen to -0.28% (-4bp) and the lowest level since January (it was 0.00% in April) – the same trend for the 2-year at -0.71% (-3bp). 10-year BTP eventually closed to yield 2.68% on Monday (+23bp), while Bonos also started to feel some heat (10-year at 1.52%, +6bp).

So equities are still a small up (month-to-date), credit spreads a ‘big’ wider, and rate markets are making hay while the sun shines on safe-haven assets. Unfortunately, we’re not seeing enough of a rally in the underlying to rescue performance from a total return perspective in credit as spreads have gapped too much, but losses for the month/year so far on this return measure are less than 1% in HY and IG credit (iBoxx index).

The pressure looks like it will remain for a while. Some clarity – or rather market-friendly news from Italy especially will be the trigger for a rally. We just can’t see that at the moment.


Credit markets have got the hump

Credit needn’t be in such dire straits but Italy especially represents the Eurozone banking sector’s bête noire. There are the obvious problems that the European banking sector will encounter even if it is much better capitalised than pre-crisis, but the contagion impact (should ‘something bad’ materialise out of Italy) will be felt far and wide. And systemically.

Nevertheless, there’s always the possibility that the new coalition sees things differently when in power. So which (hoping) investor doesn’t want to get involved as spreads have widened hard, but now find themselves waiting.. and waiting, to pick their moment? We might not be at maximum pain through this current short period of weakness, but getting ahead of the curve – any liquidity will vanish as soon as the herd joins in – is an art, albeit requiring much luck and some nerve. The possibility of having to take a short-term mark-to-market hit in order to source enough paper now – while one can – might be the way forward. Admittedly and all said, we’d be sidelined right now!

New issue opportunities are going to be hit & miss, but deals are coming with good (sometimes eye-wateringly high) premiums versus secondary – if we can believe that measure remains the most efficient one to use for pricing primary deals. Unfortunately, most deals this month are underwater versus re-offer levels. Small wonder secondary is taking a hit with sectors being aggressively repriced wider.

Nor is it as if we had an abundance of deals this year. We’re running at 30% below last year in the opening period of 2018. The supply/demand/sidelined cash balance is lopsided. We know that investor cash balances are at elevated levels and money needs to be put to work, but Italy and the non-trivial matter of a systemic crisis unfolding soon is keeping spread markets at bay.


Sit back and watch the show

The end of the month business will be Tuesday to Thursday given that the markets will slow down thereafter into the non-farm payroll report (193,000 expected, versus 164,000 in April). The hourly earnings number will be watched, as will the PCE data. In Europe, obviously it’s all about Italian and Spanish politics, but we also have Eurozone inflation numbers for May.

We don’t expect too much by way of primary market, although we wouldn’t discount some activity from low beta borrowers who might more opportunistically be able to get some deals away. Overall, though, there isn’t going to be a frenetic level of activity. Non-financial issuance levels for the year-to-date are running at the lowest levels since 2012 where we haven’t even reached €100bn (at €95bn) – and quite possibly we won’t get there come month-end, given the state of the market at the moment.

And that’s about it for the moment. The US and UK markets re-open on Tuesday. Let’s see what Italian politics throw up next.

Have a good day.


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Suki Mann

A 30+ year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on CreditMarketDaily.com.