Posted By: Matthias Paul Kuhlmey
It may appear self-serving, but with U.S. 10yr-yields marking yet another historic low (we currently show 1.62%), we wish to remind our regular readers that, against many leading opinions, we went on record recently, conveying our belief that bonds should have a place in every thoughtfully constructed portfolio. While we agree that parts of the fixed income market are very expensive and, consequently unattractive, so are equities, when considering the volatility an investor has to “accept.”
Until recently, all seemed dandy, with the talking heads estimating that the S&P 500 would trade (soon) near 1500 or even exceed 1700 by year end. With resurfaced macro concerns related to the European crisis, capital flows have been redirected into U.S. Treasuries (hence the low yield) and the U.S.-Dollar (USD); as one may expect, both assets have performed well over the past week.
What is truly concerning is not related to the political dysfunction of European policymakers, but the fact that, slowly and steadily, capital has been leaving the European financial system; for this reason alone, banks in Europe could face a payment crisis in the weeks to come (think of the lines forming in front of branches of the U.K. Bank, Northern Rock, when things became dicey in September of 2007, and multiply the effect … also keep in mind that the share price fell nearly 60% over two days, prior to a guarantee of deposits being announced).
The European financial system could simply “implode,” and, at this point, the design flaw of the European Monetary Union, specifically the lack of a fiscal transfer mechanism, will have to be addressed – no going back unless the “game is over.” The final rescue may come in the form of Eurobond issuance or simply the ECB and policymakers allowing for a “blanket guarantee” of European bank deposits. All considered, it “smells” like a nationalization of the banking system is on the horizon. We shall see.
In the shorter-term, before any major decisions emerge from Europe, we likely have to wait for the outcome of the Greek election on June 17th, and the pending visit to Greece “by the ‘troika’ of EU, International Monetary Fund and European Central Bank officials, which will decide on unlocking more bailout funds”; thus, if it is left up to Greece (i.e., if other catastrophic/euphoric news is somehow avoided), we could find ourselves in a continuation of the range-bound limbo we have experienced over the last two weeks.
Overall, we continue to expect the risk of heightened volatility in financial markets, and suggest a cautious approach to investing. For our detailed opinion on Europe and macro-related issues, please listen to our recently broadcast radio interview.