Increased risk aversion takes its toll on global equities, supporting safe-haven assets
Investor appetite slowed in the past week, with global equity markets declining across the board, government bond yields down from their recent high and gold gaining ground as risk aversion prevailed. Concerns regarding tighter financial conditions (higher policy rates and borrowing costs) going forward, amid continuing US/China trade tensions, likely prompted investors to remain cautious regarding risky assets.
Moreover, certain systematic (rules-based) investing strategies (CTAs, risk-parity funds) may have amplified selling pressures, as they seek to remain hedged when the market falls below some threshold (e.g. S&P500 below 2850) or volatility changes significantly (realized 30-day volatility was up 7.2% wow at 13.7%, a 5-month high – see graph below).
Overall, global equities declined at their fastest pace since March (MSCI ACWI: -3.9% wow | -3.6% ytd in $ terms), mainly driven by developed markets as emerging markets held their own amid robust EM FX (+0.8% wow against the USD). Nevertheless, mtd (-6.5% vs -5.5%) and ytd (-15% vs -2%) emerging equity markets lag significantly. On a regional level, US equities recorded heavy losses of 4.1% wow (+3.5% ytd), with cyclicals underperforming defensive sectors, as technology fell materially (-4.77% on Wednesday October 10th, the weakest daily outcome since August 2011). The EuroStoxx index declined by 4.8% wow (-8.3% ytd).
The Italian Government submitted its 2019 Budget with a deficit target of -2.4% of GDP, instead of -0.8% (2019) in the 2018 April Stability Programme. This level of deficit implies a fiscal loosening by more than +0.6% in 2019 (measured by the change of the structural budget balance) and likely violates EU budget rules as: i) the European Commission (in May 2018) expected Italy to tighten its fiscal stance by 0.6% of GDP in 2019 in order to ensure sufficient progress toward its Medium-Term Objective (i.e. a broadly balanced budget in structural terms); and ii) a headline deficit target of -2.4% of GDP is unlikely to be compatible with the Debt-Reduction Objective.
As a result, the negative feedback loop between the sovereign and banks continues to hurt Italian banks (-23% ytd), which hold circa €375 bn of Italian Government Bonds (93% of capital and reserves and 10% of assets according to Bank of Italy data). Italian banks also hold circa €250 bn of low-cost TLTRO funds by the ECB, which mature between June 2020 and March 2021, indicating that higher funding costs (if sustained) will weigh on their profitability with the BTP/Bund spread at 308 bps, up by 185 bps since end-April. Moreover, Italian banks’ profits are further held back by high loan loss provisions due to the still elevated, albeit declining, non-performing loans ratio (9.7% as of Q2:2018 based on EBA data from 16.6% in Q1:2016).
A deteriorating economic outlook, assuming tighter financial conditions and falling business confidence that more than offset the positive fiscal impulse, could halt the NPL improvement and aggravate pressures on the banking sector. Indeed, Italian growth has already slowed in H1:2018 (in tandem with euro area), with real GDP at +1.1% saar from +1.4% saar in H2:2017 and +1.9% saar in H1:2017, while leading economic indicators (Ita-coin: Bank of Italy) suggest that real GDP growth could stall in Q3:2018 on a quarterly basis. Overall, real GDP growth is expected at +1.2% in 2018 from +1.6% in 2017 (best since 2011).