The song remains the same

As we settle into the summer lull it is generally expected that markets drift sideways or lower as participants go away and volume dries up. This year has been so different from others in so many ways that expecting a quiet summer could be a big ask. Some of the big issues markets face have been overshadowed, at least in the UK, by the noise around Brexit.

In Europe there is an ongoing slow burn financial crisis, which given the central bank’s QE policy, has been taking place largely without the usual turmoil in financial markets. The Italian banks are the latest manifestation of this crisis, struggling under the weight of bad debts from many years ago which have never been dealt with.

Italy and the EU appear to be at an impasse regarding the degree to which investors must take losses before the state can step in and bail out a bank. In essence the EU rules require a bail in of bond holders before the government can allow a bail out of a bank.

Fair enough you might think except, unlike the UK where the vast majority of bank bonds are owned by institutional investors (including retail bond funds), in Italy retail investors own bank bonds quite widely and there are elections coming up. Retail investors, who often regard bank bonds as similar to deposits on the Continent, may have a nasty shock coming when they find the market currently values those bonds at 80c on the euro.

Another background concern for markets are the ongoing problems of the Middle East, manifesting itself in the failed coup in Turkey. Ironically although democracy may have triumphed on the day the government seems to be leading Turkey more quickly down the authoritarian path. Given that Turkey acts as Europe’s firewall against instability this is a concern.

Helicopter money

Outside of Europe another interesting development is the possibility of helicopter money policy being implemented at some point somewhere in the world. This is where the central bank lends money directly to the government to spend on fiscal policy such as tax cuts to improve economic growth.

Given the prevalence of a demand deficit, this policy may be more successful than the QE and zero interest rate policies. We need to monitor this development as it would put a challenge on our basic ‘lower for longer’ thesis.

Unless consumers adjust their spending downwards by as much as the government spends, then growth will inevitably be higher as a consequence, as might inflation. While we haven’t even seen the start of the policy let alone the outcome we aren’t going to change our portfolios. At the same time we can now see how the lower for longer theme may reach a natural end.

In the meantime the UK central bank is indicating an intention to embark on a corporate bond buying programme, similar to Europe’s, which will inevitably lead to attractive returns for bond investors keeping yields low and driving them lower. This is seen as a means of offsetting any economic weakness and improving confidence post the Brexit vote.

So, following developments in the UK, Europe and Middle East, the ‘lower for longer’ story remains very much intact in the short term. However, as economic stagnation persists we have to be alive to new initiatives that might challenge this. In the meantime, we will continue to seek returns from both falling yields and narrowing corporate bond spreads, and from those defensive equity sectors which also benefit.