Italian uncertainty: Prepare for higher volatility

Thought of the day

by Chief Investment Office 29 May 2018

Intensifying political uncertainty in Italy prompted further selling of risk assets on Tuesday. Fears that the collapse of attempts by the M5S and Lega parties to form a coalition government could lead to fresh elections and, potentially, a more explicit populist mandate pushed Italian assets sharply lower. The yield on Italian two-year government bonds tripled to an intra-day peak of 2.8% and the FTSE MIB Index fell as much as 3.7%. Selling spilled over into broader markets – the Eurostoxx 600 Index fell by up to 2%. Safe-haven assets rallied: the yen gained 0.7% against the USD and 10-year US Treasury yields fell as much as 13bps.

The sell-off in Italian assets appears overdone. The spike in two-year yields is dislocated from actual default risk and plausibly can only be explained by fears of an Italian exit from the euro. Yet on TV Monday night the leaders of both M5S and Lega confirmed they want the country to stay in the euro. An exit was not part of their respective or joint policy programs.

The market reaction confirms our view that investors should expect greater volatility this year than last. But this does not mean that it is time to sell equities. Instead, in an environment of heightened risk alongside positive potential returns, investors need to be both invested and to manage risks. Among the strategies they can follow are:

  • Holding counter-cyclical positions that can perform both in risk-off periods and in base case scenarios. For example, in our view, the yen is likely to appreciate as inflation starts to rise. It also benefits from safe-haven flows during periods of volatility. US 10-year Treasuries offer attractive yields; at their recent 3.13% high they had priced in the vast majority of the interest rate rise we expect in this cycle. Since that peak, yields have fallen on flight-to-safety flows.
  • Building in downside protection. We believe it remains important to retain exposure to market upside, given strong economic and earnings growth. But in a year with greater downside risk, it is also valuable for investors to insure portfolios against market falls.
  • Diversifying globally can help reduce exposure to specific risks. Since peaking on 7 May, Italian stocks have fallen 13%. The MSCI All Country World Index is broadly flat over the same period. Those averse to owning foreign equities can also seek out homegrown companies with high international exposure.

So we remain overweight global equities, reflecting strong global economic and earnings growth. In our global tactical asset allocation, we hold a put option, on the S&P 500 to help protect our portfolios against large equity market falls. We are also overweight 10-year US Treasuries and overweight the yen versus the USD.

For more on preparing for higher market volatility, watch this video or read our recent publication Volatility is back. Are you prepared?

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