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July 30, 2018 at 03:53 PM
The second half of 2018 is looking a lot like the first half of the year for equities, with policy speculation and geopolitical risks dominating the headlines. Distinguishing between news and noise is critically important for investors. For example, concerns about a potential exit of Italy from the euro area is more likely to be noise, creating trading opportunities. In contrast, developments on trade policy or in technology sector growth may be more newsworthy, providing insight into the prospects for equities.
3 Issues That May Be More Noise Than News
1. President Donald Trump’s tweets and statements criticizing the Federal Reserve: For perhaps the first time in his presidency, Trump may be on the same page as Sen. Rand Paul, son of Ron “End the Fed” Paul. Trump’s criticism of the Fed’s interest rate hikes disturbed many Fed-watchers, but does not jeopardize the independence of the Fed. Although recent presidents have refrained from criticizing the Fed, Trump is not the first president to be critical of Fed policy.
Trump’s appointees to the Fed have signaled their independence, providing consistent reminders of the Fed’s dual mandate to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” Lessons from the past, including mistakes made by Fed leaders under pressure from Presidents Johnson and Nixon, haven’t been forgotten by the current leaders and staffers at the Fed.
2. Italy exiting the euro area: Italy has serious long-term issues, but the near-term risk of “Italexit” is slim. Italian credit spreads recently widened after reports that the leaders of Italy’s coalition government were pressuring Finance Minister Giovanni Tria to resign. Investors think of Tria as the “voice of reason” in a government led by “magical thinkers” wanting to dramatically increase Italy’s fiscal deficit.
Italy’s financial challenges are considerable. Stagnant incomes, high government debt, low worker productivity and high youth unemployment have created an environment in which populist solutions appeal to Italian voters. Despite mutual frustration, Italian and euro area leaders both face constraints that make worst-case outcomes less likely. Italian populists are constrained by a weak banking system and high retail ownership of bank debt.
Legal barriers are also an issue for those who favor an “Italexit.” The Italian Constitution prohibits a referendum on treaties, so a Brexit-like referendum isn’t in the cards. Europe, particularly Germany, is constrained by the magnitude of Italian debt and liabilities held by foreign investors. Given these constraints, Italy’s problems are likely to be “kicked down the road” for an extended period of time.
3. Inversion of the yield curve: The yield curve, as measured by the spreads between 10-year and 2-year Treasury yields, has been flattening since early 2011, when the spread peaked at nearly 2.9%. The spread recently broke below the 30 basis-point level. An inverted yield curve, which is when the 2-year yield is higher than the 10-year yield, is considered one of the most reliable indicators of an upcoming recession.
