It's Not Just Italy. Shock Moves Jolt All-Or-Nothing Markets

(Bloomberg) -- What do Toys “R” Us bonds, the populist threat to the European Union, and Turkish external debt have in common?

All were tolerated by market players until, quite suddenly, they weren’t.

Investors seem increasingly prone to flee assets at the first hint of trouble, fueling concern more cracks are appearing in global markets that have been papered over for years by easy money. That climate saw cash simply herded into any investment with a respectable yield. The swift reaction to a twist in Italy’s political drama last week looks like the latest sign.

“The binary ‘all-in/all-out’ behavior, which up until now was relegated to the fringes of the financial markets, has gone mainstream,” Peter Atwater, president of Financial Insyghts, said of the market’s rapid repricing of Italian default risk. “Investors are becoming increasingly manic,” he wrote in a note.

Atwater points out that the surge in the Italian two-year yield resembled the moves in Kobe Steel Ltd. bonds last fall, as well as those seen in debt from Steinhoff International Holdings NV, Venezuela and even Toys “R” Us Inc. The price of the toymaker’s bonds due 2018 plunged September last year to the mid-20 mark when the company filed for bankruptcy protection, down from 96 cents just two weeks earlier.

This global phenomenon is well-known. Economist John Kenneth Galbraith called it the “Bezzle,” referencing the period in which an embezzler has stolen money but the victim doesn’t yet realize it. Perhaps most famously, Warren Buffett put a typical homespun-style on it when he said, “Only when the tide goes out do you discover who has been swimming naked.”

For Matt Maley, equity strategist at Miller Tabak + Co., it’s all about “mal-investments.” He warns that while U.S. stocks have so far weathered the shifting narrative across global markets, they will inevitably feel the impact of monetary tightening as problems spill over.

“It takes a while before the rise in rates starts to impact the markets, but their rise always exposes the mal-investments that have developed during the period of time when rates were going down,” he said. “Last week’s developments were just the newest ones in a progression of ‘cracks’ that have been showing up in the markets since late January.”

Ripple Effect

There are few clearer examples than in emerging markets, where investors have suddenly ended their love-affair with a bevy of higher-yielding assets.

Developing-nation stocks declined for a fourth month in May, the longest run since 2016, currencies extended losses from April, and local bonds fell for second month. Emerging markets have been battered by seven weeks of dollar gains and by the yield on benchmark 10-year U.S. bonds testing the 3 percent level.

“If you break through that 3 percent, 3-and-a-half percent, those real psychological barriers in the 10-year, then you start to see the ripple effect,” Emad Mostaque, co-chief investment officer at Capricorn Fund Managers Ltd., said in a Bloomberg TV interview. “A lot of the classical spreads that we’ve seen, for example euro junk bonds to U.S. 10-year, those have just gone crazy and weird. And they have to normalize eventually just on a fundamental basis.”

One of the first indications has been the slide in the Turkish lira, according to Mostaque. The currency has weakened about 18 percent against the dollar this year amid concerns about an overheating economy, Turkey’s vulnerability to higher global interest rates, and economic policies under President Recep Tayyip Erdogan.

Recent events in both emerging markets such as Turkey and Argentina and developed markets including Italy prompted Algebris Investments to launch its Tail Risk Fund last week. The firm said 10 years of loose monetary policy has distorted asset prices and that economies and financial systems look “increasingly fragile.” The fund aims to counter potential shocks via a short bias and a portfolio of hedging strategies.

“The unwinding of risk is following its expected path,” Atwater wrote. “Over the past six months, we’ve seen an unwinding of cryptocurrencies, the short vol. trade, emerging markets (stocks, bonds and currencies) and now Italy -- the perceived weakest after Greece in the eurozone. The worst and most extreme have gone first.”

©2018 Bloomberg L.P.

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