Italian political drama hits home

by: , Strategic Asset Allocation & Solutions Group, New York Life Investment Management

“The upcoming elections will not be political, but instead a real and true referendum, between who wants Italy to be a free country and who wants to be servile and enslaved.” – Matteo Salvini, leader of the Northern League

The S&P 500 sold off 1.15%, while Treasury bonds soared, as some investors fled for safety, fearing turbulence from political drama in Italy. The lurking story is financials, down more than 3% on the day.

What’s going on here?

Recently, investors have become more concerned that European elections will deliver an even stronger mandate for anti-establishment, Eurosceptic politicians. Beginning in May, the resurgence in fears of an Italian exit contributed to the widening of the spread between Italian and German bonds and a weakening of the euro.

Yesterday, yet another drop fell into place, when Italy’s President Sergio Mattarella rejected the coalition government’s cabinet proposal. Tensions escalated from there, and as a result, spreads widened to nearly 300 bps – the widest level in five years, and Two-Year Italian bond yields moved the most in history – data back to 1993 (Figures 1 and 2).

Figure 1: German-Italian 10-year yield spread

Source: Bloomberg, as of 5/29/18. An investment cannot be made in an index. Past performance is no guarantee of future results.

Figure 2: Two-year Italian bond yields moved the most in history

Date Two-Year Yield Change
5/29/2018 2.8 186.3
8/12/1994 11.6 99.0
11/9/2011 7.2 82.3
7/11/2011 4.2 69.7
7/23/2012 4.6 68.8
11/22/2011 7.0 58.3
12/8/2011 6.2 57.8
9/5/2011 4.1 57.6
6/25/2012 4.3 53.7
11/23/1993 10.1 53.1
3/17/1995 13.0 52.3
11/7/2011 6.0 51.3
11/15/2011 6.5 48.8

Source: Bloomberg, as of 5/29/18. Daily history on Italian 2-year yields ends in 1993.

Figure 3: We haven’t seen a move in the 10-year yield like today in almost two years

10-year Treasury yield one-day change

Source: Bloomberg, as of 5/29/18. An investment cannot be made in an index. Past performance is no guarantee of future results.

The yield on the 10-year Treasury bond fell by 0.15%. The last time we saw a move of that magnitude was during Brexit, which accompanied a much bigger move in the U.S. equity markets than we saw today.

Figure 4: Financials took an undeserved beating

Financials’ excess return vs. change in yield in 10-year Treasury Bond

Source: Bloomberg, as of 5/29/18. Data begins in 2017. Indexes represented are 10-year U.S. Treasury, S&P 500 Index, and S&P 500 Financials Index. All index definitions can be found at the end of this post. An investment cannot be made in an index. Past performance is no guarantee of future results. Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. R-squared is a statistical measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index.

Financials underperfomed by 2.2% today, making it a bit of an outlier. Yes, risk-off events usually hurt U.S. banks, as the area under the yield curve falls, but a simple beta-adjusted regression of U.S. 10-year yield changes implies a decline of only 1.3%. We have not observed any factors in play that justify such a strong move.

Bottom line

Looking ahead, Italy will likely have new elections as soon as July. All the usual suspects will return to the table. Our assessment:

  1. We are skeptical that an election will be perceived as a referendum on the euro, but the news media may frame it that way.
  2. With contentious Brexit negotiations heating up, we find it hard to believe that Italians would see an exit from the euro as being a solution to the current problems.

We were keen on European assets not long ago; while yesterday was an overreaction, we are slightly less excited about holding them today. The drawdown on U.S. banks may make a good buying opportunity.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.

Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months, and pays the face value to the holder at maturity.

Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

The beta-adjusted exposure is a modified measure of exposure that is used for investment funds or portfolios.

A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.

Germany Generic Govt 10Y Yield – The rates are comprised of Generic German government bonds.

Italy Generic Govt 10Y Yield – The rates are comprised of Generic Italian government bonds (Gross Yields-before taxes).

S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance.

The S&P 500® Financials Index comprises those companies included in the S&P 500 that are classified as members of the GICS® financials sector.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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SAS Group

Strategic Asset Allocation & Solutions Group, New York Life Investment Management

NYLIM’s Strategic Asset Allocation & Solutions (SAS) Group invests tactically across the full span of global capital markets, designing comprehensive solutions for a variety of client needs. Managed assets include MainStay Asset Allocation and Retirement Funds, mandates for third parties, and a customized strategy for the New York Life General Account.

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