Big wolves, small wolves

 By Guest Blogger Doug Rowat

The nine-year US bull market has been looking a bit rickety recently. And the constitutional crisis in Italy has become the latest cause for concern. Italy’s president, who holds a head-of-state position that normally remains politically neutral, has broken from tradition and inserted himself forcefully into the process of appointing and denying key governing positions. It would be a bit like Canada’s governor general suddenly telling Trudeau who he can and can’t have in his cabinet.

Now the cobbled-together coalition government of the populist, anti-establishment Five Star Movement and League parties has been essentially paralyzed. The bottomline: we’re likely to see another Italian election by September with the potential to have the same messy outcome as the one that just occurred in March.

Well, the market clearly doesn’t like what’s happening. European stocks have plummeted almost 5% in the past two weeks, with the Italian market down roughly 10%, and we suddenly have the following situation: A European nation ravaged with debt, its bond yields beginning to soar and an inexperienced, strident (and, frankly, still unformed) government itching to flip the bird to the Eurozone. Sound familiar? Except that this time it’s not Greece, this time it’s a country that’s Europe’s third largest economy with a debt level totaling a massive EUR2.1 trillion (a debt-to-GDP ratio of 132%—Canada, by comparison, sits at about 90%). There ain’t nobody going to forgive that much debt.

So a massive crisis is looming and investors should clearly position portfolios defensively and wait out the imminent market sell-off.

That’s certainly one option. Another is to focus on a broad series of fundamental indicators that have reliably signaled US recessions and market downturns in the past. Bear markets generally coincide with recessions. Currently, the key factors we follow aren’t signaling a problem:

A US Recession not Indicated

Source: Bloomberg, Turner Investments

In a pinch, if you had to rely on only one indicator, the Conference Board’s Leading Economic Index would be a pretty good choice. The Index includes components ranging from S&P 500 equity prices and worker wages to manufacturing levels and unemployment insurance claims. Isolating this one, quite predictive index indicates why we remain unconcerned regarding the US economy:

Conference Board US Leading Economic Index still rockin’

Source: Bloomberg, Turner Investments

But Italy isn’t Greece is the argument of the bears. Italy is more significant with a much larger debt load and a more meaningful banking sector. An economic crisis here is inevitable and would spread quickly.

Perhaps. But recall that many market pundits were expecting an economic disaster for China in 2016. Remember Royal Bank of Scotland (RBS) advising clients to brace for a “cataclysmic year” and to “sell everything except high quality bonds”? China, of course, is the world’s second largest economy with 1.4 billion people and a crisis here would have far eclipsed Italy’s. But we survived. Since the RBS recommendations, the S&P 500 has advanced 47% and even the Shanghai Shenzhen CSI 300 Index is up 24%, including dividends.

We also had the shocking Brexit vote in mid-2016, a decision that was forecasted to devastate the UK economy and lead to a plunge in UK equity markets. The New York Times alarmingly stated just prior to the vote that “‘Brexit’…could sink Britain’s economy”. The UK economy is the world’s fifth largest. Again, this was far more serious stuff than Italy. But, again, we survived. The UK economy has grown nearly 2% in each of 2016 and 2017, a decent growth rate, and the FTSE 100 (London) has advanced 31%, including dividends. And Britain’s exit from the Eurozone seems to be proceeding in an orderly fashion.

Regarding Italy, you’re going to see a lot of headlines in the coming months flashing “crisis”, or some other frightening equivalent, and they will imply that the disaster will soon spread, thus negatively impacting US markets. Ignore these headlines. Block out the fear. Focus instead on the indicators that are most reliable for forecasting the direction of the US economy and its stock markets. These indicators are stable.

Headline risk. It’s the worst. And it’s best summed up in Italian: Si dice sempre il lupo più grande che non è. Translation: The wolf is made bigger than it is.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.