We spent a part of last week’s blog discussing the UK Supreme Court’s verdict on triggering Article 50, and the first round of the French Socialist elections. Given all that happened last week, we thought it appropriate to share our thoughts on market implications. In the UK, the Supreme Court, as anticipated, ruled that Parliament should vote on the triggering of Article 50. The verdict was widely anticipated, and had little effect on markets. We still think UK Gilts could underperform in the coming months. In France, we noted last week the surprise victory of Benoit Hamon in the first round of the Socialist Party elections, and over the weekend Hamon won the nomination of the centre-left Party. The baseline scenario is still that the Conservative party candidate Francois Fillon will face, and defeat, Marine Le Pen in the second round of the Presidential elections. But recent polls suggest Mr. Fillon is losing momentum, and last week he faced accusations about his wife’s involvement in his campaign. This has led to speculation that independent candidate Emmanuel Macron could emerge as the candidate to face Ms Le Pen in the run-off. Currently, Mr Macron polls even higher than Mr Fillon against Ms Le Pen. We believe markets would react favourably to either a Macron or a Fillon victory, with French bond spreads tightening against Germany. Finally, the Italian Constitutional Court’s ruling last week means that a second-round head-to-head vote-off between the two most popular parties (in the event of no party achieving 40% of first round votes) is unconstitutional, and no longer an option. This is important, as it conceivably could have given 5Star a chance of being the sole party in government. We believe the ruling may bring forward the possibility of early elections (perhaps in Spring or early Summer 2017). However, it appears likely that some form of coalition could be the outcome of any election. Whether that coalition would have a long or effective life is another matter, and was the primary reason for Italian sovereign BTP’s underperforming following the ruling. We like Italian BTP’s, particularly when bought on a spread basis against German Bunds, and would see any weakness as a buying opportunity. Overall, we think that political risk is slowly being worked through in Europe. We now have some clarity on the UK Brexit path and timeline, the French elections are beginning to show the emergence of a market-friendly Prime Minister (either Mr Fillon or Mr Macron) and with yesterday’s ruling, the chances of 5Star being a majority party in an Italian government have receded. That gives us reasons to be optimistic on peripheral European sovereign debt at current valuations.
2. German Inflation – Headache for the ECB?
At the last ECB press conference, ECB President Mario Draghi outlined four conditions that needed to be achieved before the ECB would consider that their inflation objective had been met. One of those conditions was that inflation should be considered in the context of the whole Euro-area, and not just one country. This was seen as a direct riposte to Germany, who in recent months have become increasingly concerned, and ever more vocal, about the rise in German inflation. Whilst the December Euro-area headline inflation number was reported at 1.1%, in Germany it accelerated to 1.7%. When the January numbers are reported later this week, it is expected that the headline Euro-area number could accelerate to 1.5%, but that the German inflation rate could hit 2% for the first time since 2012. Last Friday, German import data for December showed an annual increase of 3.5% compared to a paltry 0.3% in November. Perhaps the most alarming measure is the core inflation rate – in Europe, even though headline inflation is increasing, most of that increase is coming from a higher oil price. The core rate, which strips out Energy, is still stagnant around 1%. However, in Germany the core rate has doubled from 0.8% in January 2015 to 1.6% in December 2016 –quite enough to cause palpitations within the Bundesbank headquarters on Wilhelm-Epstein Strasse in Frankfurt. This may explain why ECB executive board member Sabine Lautenschlager last week noted that she was “optimistic that we can soon turn to the question of an exit” from easy monetary policy settings. No surprise then that German 10-year Bund yields ended last week close to 0.50%, up nearly 30bps from end-December levels. As we move through 2017, we expect to hear increased calls for ECB tapering, which should put upward pressure on European bonds yields. In our opinion, a short duration stance is warranted.
3. Correlation Breakdown
In 1969, Led Zeppelin released their debut album (imaginatively entitled “Led Zeppelin”), which featured the song “Communication Breakdown”. This song either opened shows or was played as an encore and was the only song played every year the band toured. Last week all the old Zeppelin fans (and some younger ‘Beliebers’) were talking about something not seen for quite a while – the breakdown of correlations between asset classes. And as we dug a bit further into this breakdown, we found that it wasn’t just across asset classes, but also within asset classes and geographic areas as well. Morgan Stanley highlighted the phenomenon with a great chart (see below) that proved the old saying “a picture paints a thousand words”.
Source : Bloomberg, Morgan Stanley. Data as of January 2017.
In our opinion, it highlights the fact that as the focus turns from monetary policy to fiscal policy; central banks have ceased to be the drivers of asset prices. Coupled with an increasingly uncertain geopolitical backdrop, the possibility for idiosyncratic risk has increased (think Trump’s spat with Mexico, UK Supreme Court ruling on Brexit, Italian Constitutional Court decision on Italicum law and upcoming French elections). All of these events have the capability to be big news events in their local markets, but maybe not as significant on a global scale. Since the Global Financial Crisis in 2008, central banks have been the major influencers of asset prices as their unconventional and extraordinarily easy monetary policies have pushed valuations ever higher. But now with different central banks on different paths ( U.S. hiking rates, Europe still engaging in Quantitative Easing), correlations within bond markets are breaking down. The chart below shows the spread between 10-year US Treasuries and 10-year German Bunds (top chart), and the correlation between the two (bottom chart). The spread is at levels not seen since February 1989 (when Simple Minds topped the UK charts with “Belfast Child”), whilst the correlation has fallen from over 0.90 in early 2016 to 0.52 now.
In theory, this should provide an opportunity for active managers to display their skill set, and for “global-macro”-type fixed income managers to profit from the uncorrelated movements in various bond markets. One last point, however – we understand that uncertainty isn’t the same as volatility, but we do find it strange that increased geopolitical uncertainly and falling correlations are not reflected in volatility measures – last week the VIX index (which measures the volatility of the S&P 500 equity index) fell to levels last seen in January 2007. We all remember what happened a year later.