“Risk off” was the order of the day as Italian concerns spread into assets and equity indexes around Europe and the US fell over 1%, US treasuries rose as the Vix hit its highest level in a month. Appearing on Bloomberg radio on Tuesday we were questioned as to the potential for further market disruption and is this an opportunity to be buying Italian bonds or US equities?
One of the flaws for the euro is clearly being displayed currently as the spread continues to widen between German bund yields and Italian ones, despite both denominated in the same currency. In theory, buying Italian bonds yielding 3% and selling German ones 0.3%, both priced in Euros should be a safe bet. The gap would suggest that speculators still see a risk the euro survival in its present form is not guaranteed and pricing in a risk.
Other questions posed, should you be buying US equities or equities in general at this point in time? The answer to that question is possibly found by analysing what of the current concerns are likely to have implications for economic growth, and what is the probability of them occurring. Are the problems in Italy likely to affect global growth? On their own no, but the potential for the euro’s structure to be challenged could have a major impact. How does one price that sort of likelihood? It is almost impossible, as the outcome could have major implications and is unprecedented. Fortunately, the political will to maintain the euro in its current form remains strong. Geopolitical risk is high on the agenda with North Korea, even though those concerns seem to be dwindling. Again, should current events take a turn for the worse and the situation with North Korea worsens we may have greater concerns?
What are the fears that have a history of causing an impact on global growth that also may be on the horizon currently? A strengthening dollar for its potential impact on emerging economies as they tend to borrow in dollars. History has examples of a strong correlation between the strong dollar and weakening emerging market growth. With the growth of the Chinese economy emerging markets make up a much larger part of the global economy than they did a 10 or 20 years ago.
Trade wars again can impact prices and consumer spending and have a negative growth implication historically. The oil price has slipped over the past few days, but a rising oil price has eventually preceded an economic recession as it finally chokes growth and consumption.
So, as an investor one must take current events on board try and calculate in their own mind the probability of the outcome to decide if the markets have overreacted. Then one can decide for themselves the answer to the questions posed today by Bloomberg journalists.