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Spread Italy versus Germany has reached a 30-month high: market pricing is already under stress

28 November 2016

When a portfolio manager loses money, he has two options:

  • Either he remains convinced by his views and keeps his positions. Even better, adds to them if conditions allow for it.
  • Or he thinks he is wrong and cuts his risk.

We have been wrong for the last 10 days on our main themes, and so we spent the last 10 days reviewing our investment themes’ fundamentals.

What are our themes?

  • US yields: we thought US core yields were too low a few months ago and inflation expectations were too low as well. This is no longer the case:
    - First, we do not share markets’ optimism about Mr Trump, who has become over the last 10 days the solution to every problem (reflation, government spending, etc.).
    - We think the impact will probably be limited on growth (+0.1 or +0.2% GDP) and it is too soon to price it. Global gross domestic product stays close to 3%, there is no significant pickup.
    - Excess saving stays elevated and US yields have come back to attractive levels in our opinion. US 5y5y forward yields is close to 3%, above Federal Reserve’s LT dots, which looks decent to us.
    - Same for inflation anticipations which has risen from 1.5% to 2% over the last 2 months, and is close today to US core inflation.
  • US Dollar: spreads between US and other areas are widening, and it is positive for the dollar. We do not think this move can last much longer for the following reasons:
    - The dollar is expensive, sometimes very expensive vs other currencies (Euro/Yen/Sterling Pound).
    - US current account balance and trade balance remains deeply in the red versus massive surpluses in Eurozone and Japan.
    - Potential rising deficits thanks to Mr. Trump are negative for the dollar.
    - Inflation could be on the rise, which is also negative for the dollar over the medium term.

  • Italy: this position is highly trying and rather controverted. Is there a risk on Italian assets going into Dec. 4th referendum? Yes of course. Are we compensated for taking this risk? We say yes. Not by a very large margin, but decently:
    - Spread versus Germany has reached a 30-month high: market pricing is already under stress.
    - The European Central Bank support is still operating and this prevents markets from collapsing like in 2011-2012; By the way, the ECB will be meeting on Dec. 8th, which is 4 days after the referendum.
    - Investors are already heavily underweighted on Italy
    - A “no” vote is already priced by the market, and there will be few surprises. Surprises – if any – will come afterwards and will be either positive or negative.

These three positions explain the rough patch we’ve experienced over the past 10 days.

It does not mean we will not change our opinion on our themes if facts change (Populist party elected in Italy? Very hawkish Fed?) but so far, our analyses drive us to keep our positions on. We are highly aware of our trying approach, which explains why they are not very large in terms of risk.

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