Unpacking the Italian Bond Crisis
By Tim Courtney, Chief Investment Officer
If you’ve been paying attention to the financial news cycle recently you may have seen that the Italian financial markets – and bonds in particular – are in a state of turmoil. The 2-year Italian yield1 jumped from negative territory one month ago to over 2.7 percent last week before hovering back around 1 percent in recent days.
Source: CNBC (https://www.cnbc.com/quotes/?symbol=IT2Y-IT)
Most of the recent volatility has to do with political upheaval. Most recently, the development of new government factions has sparked concern that Italy could mobilize on its own “Brexit” movement2, ultimately disentangling itself from the EU and, in the process, the Euro.
This news sent shockwaves through the bond market, resulting in much more violent moves than investors were accustomed to. With little to negative yield, we believe European bonds are among the most expensive assets in the world and priced for perfection, leaving very little room for error. Even the slightest news upset could result in significant volatility, which is what we experienced recently.
On the other hand, European equities are still trading at steep discounts, approximately 30 to 40 percent less expensive3 than those in the U.S. This is because much of the political and economic risks in Europe have been factored into their pricing, which is why the equity market, while still affected, has reacted much calmer in the face of recent political news.
Currently, U.S. equity markets4 are themselves priced relatively high with the expectation that strong economic growth and profitability will continue. So far, recent news has matched those expectations. The U.S. is still viewed as the most stable and trustworthy market in which to invest and it appears 2018 is on track to set new earnings records for the S&P 500 companies.
However, just as with the Italian bond market, higher priced assets have less margin for error. While it doesn’t appear that numbers are softening in the U.S., if we were starting to see surprising and disappointing numbers we would expect prices to adjust lower. This is not dissimilar to what has recently occurred with U.S. bond prices. In July of 2016, the 10-year U.S. Treasury was extremely expensive, yielding only 1.37 percent5. This period capped off a 35 year bonanza for bonds as annual returns from July of 1981 to July 2016 were 8.22 percent annualized for the U.S. Aggregate Bond Index. In the two years since then, the bond index is down 2.32 percent (as of June 6).6
As investors, we should be ready to experience higher volatility following years of very quiet volatility and steadily increasing prices. While it is unlikely that we would see a meltdown like the one going on in Italy, it’s a lesson on how quickly things can change in markets, and why diversification in assets is so necessary.
3 DFA Fund Valuations as of 4/30/2018
6 DFA Returns 2.0
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