Calm markets peer beyond U.S., Italian political storms

Reuters

By Jamie McGeever

LONDON (Reuters) - Despite a constitutional aversion to uncertainty, financial markets have breezed through political storms in two of the world's biggest economies, thanks to cool calculations that the crises will not trigger major shifts in investment.

As budget stalemate shut down government in the United States and political manoeuvring took Italy's to the brink of collapse, asset managers figured that neither crisis - despite involving the Republicans' unpredictable Tea Party wing and mercurial former Italian premier Silvio Berlusconi - will be disruptive enough to undermine their long-term views.

The strategy is to get away from "trying to pretend you know what's going to happen in any one event", said Alan Wilde, currency and bond portfolio manager at Barings Asset Management, which has $58 billion (35 billion pounds) of assets under management.

"There's no easy way to trade unknown factors. One way is to take a view, but you're either horribly right or horribly wrong," he said.

For long-term investors to change their views, and thus spark sharp market moves, political instability would have to dent economic growth or trigger high and sustained volatility.

"The key challenge is trying to understand whether any bout of political volatility is sufficiently large to alter the path of the economy," said Mike Amey, UK portfolio manager at PIMCO, the world's largest bond fund.

"Ultimately, we doubt that this will be the case in either Washington or Rome," said Amey, who manages 8 billion pounds ($13 billion) of assets.

Italian Prime Minister Enrico Letta faced a confidence vote on Wednesday, triggered by Berlusconi, that could have spelled the end of his coalition government, raising doubts about fiscal and economic reforms.

Even before the billionaire media mogul's last-minute U-turn appears to have averted the danger, markets had been mostly undaunted through the thick of the crisis.

After an initial spike last week, Italian 10-year bond yields had fallen even further back before the danger passed.

It was a similar story after inconclusive Italian elections in February. Bond yields rose sharply towards 5 percent in the run-up, but during the subsequent weeks of uncertainty, investors piled in and pushed them below 4 percent, even before the new government was formed.

Overseas investors' holdings of Italian government bonds throughout that period stayed at around 35 percent of the total.

FEAR OF THE UNKNOWN

The U.S. government partially closed down at midnight on Monday after Congress failed to reach a deal on the latest budget bill. This sharpens the focus on a mid-October deadline, when failure to raise the $16.7 trillion debt ceiling could result in an unprecedented default, a seismic event that would have a huge impact on markets.

There has been at least one shutdown in every U.S. administration, except that of George W. Bush, since Gerald Ford was president in the mid-1970s, and markets' central case is that this latest instance will not last long.

The Peterson Institute for International Economics in Washington has calculated the shutdown would shave 0.15 percent off GDP growth per week. Even a 22-day closure, as happened under President Bill Clinton, would only trim about 0.2 percent off GDP, Credit Suisse says.

There is no definitive cut-off point that might trigger a pull out, but the longer the shutdown goes on, the greater the impact on the economy and investments.

If fear of the political unknown ran deep, investors would be snapping up safe-haven assets, but so far this week U.S. Treasuries, German Bunds and UK gilts are flat, while gold is sharply lower.

The Swiss franc, the closest thing to a safe haven in foreign exchange, is also unchanged this week. World stocks are only down 0.4 percent, and the VIX "fear index" of U.S. stock market volatility is flat - hardly signs of panic.

Both Barings' Wilde and PIMCO's Amey say that rather than change their portfolios they would first look for cheap ways to "hedge" - or protect - their investments in the face of unforeseen and potentially harmful political developments.

WHOLESALE CHANGE

Sometimes, the calculation is that political uncertainty is so deep that a wholesale change of direction is warranted.

In the run-up to the 2010 UK general election, PIMCO's chief investment officer, Bill Gross, famously warned that British government bonds were "resting on a bed of nitroglycerine".

PIMCO dumped their gilts for German government bonds. This was not a bet against bonds per se, but a vote of no-confidence in how the new British government would deal with its huge debt and fiscal challenges, Amey said.

In a sign of how difficult these calculations can be, the 10-year gilt yield, which closed at 3.81 percent on election day, later embarked on a major bull run that took it to 1.41 percent by late July 2012.

For now, investors trust that politicians in Washington, following the example in Rome, will avert disaster at the 11th hour.

"Even if you are an avid follower of politics on both continents, it is almost impossible to forecast how the whole situation is likely to unfold," said Andy Ji, Asian currency strategist for Commonwealth Bank of Australia in Singapore.

(Additional reporting by Masayuki Kitano in Singapore; editing by Nigel Stephenson and Will Waterman)

View Comments (0)