The market turbulence caused by political upheaval in Italy revealed cracks in the eurozone that had been papered over by QE. Nicholas Wall, fund manager of the Strategic Absolute Return Bond fund, argues that there is no room for complacency as the era of abundant liquidity comes to an end.
Three months of political uncertainty in Italy and the market turbulence that followed has been a wake-up call for anyone who has grown too accustomed to the European Central Bank’s (ECB) quantitative easing (QE) programme.
Investor unease in Italy started with an inconclusive election result in March and escalated after two eurosceptic parties formed a coalition government, raising concern about the country’s future in the euro. Bond yields climbed and the euro tumbled, exposing the fragility of a market that has already been buoyed by the ECB.
The QE era of tight bond spreads, low market volatility and abundant liquidity can no longer be taken for granted. As the central bank’s bond purchases come to an end and cracks start to re-emerge, there will be far reaching consequences for investors, the European Union and individual governments in the eurozone.
Security trading has changed over recent years because of new regulation, cost of capital constraints and automation. Bank trading desks are now less able and willing to warehouse risk, particularly when volatility rises and risk limits are hit. This means that when investor sentiment turns, as it did over Italy, price moves can be rapid and spread quickly to other markets.
So far these episodes have been short-lived because it is hard to stay short European risk given the ECB’s presence in the market. This will likely change once the central bank removes its QE safety net.
We have already seen the market impact when the US Federal Reserve took steps to reduce its balance sheet and increase Treasury bill issuance. Popular market positions were wiped out from painful corrections in US equities, subordinated financial debt, short US dollar and inverse volatility products. In our view, this will be an ongoing theme.
Investors need to be mindful of how the market is positioned and be wary of popular trades and liquidity conditions. The cycle is maturing which typically creates volatility, just at a time when the exit has narrowed because of constraints on trading desks and when central banks are less willing to offer support. The carry trade, where an investor borrows at a low interest rate to buy bonds in a higher yielding region, is no longer the only strategy in town. The return of volatility will present opportunities, but investors will need to be patient.
The concept of an “ever closer union” enshrined in EU treaties was severely tested once again when Italy scrambled to form a government. At the heart of demands from the now ruling populist parties was for Italy to have more sovereignty over its finances. This sits at odds with the EU’s goals to see greater convergence. Italy has already given up some sovereignty and has been asked for more. But despite the abundance of liquidity from QE, the country has yet to enjoy higher growth or benefit from any EU-wide sharing of risk, which has fuelled discontent among voters and bolstered anti-EU sentiment.
The EU is a political project and while strengthening the system is a good idea, asking countries to give up their sovereignty is a delicate process. It took nearly 150 years for the US to have a political, economic and monetary union. If federalism is the endgame for the EU project, it still has a long way to go. Opportunities to accelerate integration, such as when Britain leaves the EU, may not strike the same tone as before.
Low-debt countries in northern Europe have placed the burden of a post-crisis adjustment on their poorer southern neighbours who have been asked to enact structural reforms and austerity measures. While the south has been slower on structural reforms, their large current account surpluses are indicative of a huge internal adjustment where domestic demand has fallen as exports increased.
For countries looking to avoid further crises and avert the rise of populism, especially as QE winds down, creditor countries need to increase domestic demand by spending more at home. With a currency lower than where their national currency would have been, households are being taxed at the expense of exporters. Governments should redress the balance by recycling their trade surpluses into the domestic economy and boosting demand. This would also alleviate the burden on the high-debt economies, and improve intra-EU relations.
Governments cannot be complacent because demands from debt investors are a lot more fickle than the ECB. There are still issues yet to be resolved – structural reforms have not gone far enough to boost productivity, youth unemployment has not been addressed and debt levels remain elevated.
So far there has been little impact on bond spreads because of the presence of the ECB in the market, but expect that to change.
For high-debt eurozone countries, they cannot solve their problems by printing more euros. Fiscal laxity will not only see higher yields but also run the risk of debt service costs rising to unsustainable levels. If that happens, they will find themselves once again caught in the Keynesian debt trap.
In summary, the abundance of post-crisis liquidity has concealed cracks in risk markets. As QE winds down and liquidity is drained, everyone will need to tread a lot more carefully.