#Market Strategy — 30.05.2018

Strong Return Of Risk Aversion

Roger Keller

The political situation in Italy is the trigger for a marked return of risk aversion. Market volatility is likely to remain high for some time, with a lack of catalysts to restore confidence quickly. However, fundamentals remain favourable so we maintain our positive medium-term views

Political uncertainties in Italy plunge the markets into doubt

The prospect of fresh elections in Italy just after the summer is proving to be the catalyst for a steep rise in volatility in financial markets. The yield on the 10-year Italian government bond rose from 1.78% at the beginning of the month to 3.10% today. The Italian stock market continues its downward spiral (it shed nearly 3% this morning, Tuesday 29 April), representing a 12% decline since mid-May. The financial sector, accounting for 37% of the MIB30 index, was the biggest victim amidst emerging fears about the vicious circle between government bonds and their holding by the banking sector, which some observers believe could lead to financial instability. Moody's announced a few days ago that it had already placed Italian bonds on its “Negative Watch” list.

The repercussions extend beyond Italy. The euro is trading at 1.1550 against the dollar, the yen and the Swiss franc. In bond markets, yields fell not only in the "core" eurozone countries, but also in the US, where the 10-year Treasury bond now offers less than 2.90%, while they are rising sharply in the so-called "peripheral" eurozone countries. Equity markets have shed 1.50% in the eurozone and are expected to fall in the US.

Volatility is set to last

Other sources of stress have come on top of uncertainties in Italy. We cite for example Spain which is moving towards a vote of confidence for the current government because of large corruption scandals within the Popular Party. Meanwhile trade tensions exist between the eurozone and the US, and between the United States and the rest of the world (NAFTA, China, etc.). Of course, geopolitical uncertainties are also high and elections in Turkey, Brazil and Mexico are not taking a reassuring direction for investors.

From a more fundamental perspective, economic data expected in the coming months should confirm a moderation in economic activity and stronger inflationary pressure, which should fuel investor caution.

The global environment remains supportive

If news flow proves to be unfavourable in the short term, i.e. during the summer, we remain positive in the medium term. Although risks are higher and more numerous than usual, we do not expect them to be sufficient enough to reverse the prospects of sustained above-potential global growth in 2019 and gradually rising inflation. The tightening of monetary conditions may, if necessary, continue at an even more moderate pace than expected. Companies will therefore continue to generate high cash flow and increase profits.

We therefore maintain our expectations of an upward trend in bond yields and equity markets. We stick to our preferences for Investment Grade corporate bonds with a short-/medium-term duration, as well as for pro-cyclical stocks and sectors. Also we still anticipate few major developments in currency markets: the euro is expected to gain some ground against the dollar and the yen should not move away from current levels in 12 months. Alternative Investments remain very good investments in an environment of increased dispersion of performance and gold is a very good diversification asset.

In practical terms, we recommend considering the phases of increased volatility as investment opportunities for a 12-month horizon. Various opportunities are expected during the summer.