Uncertainty over Italy’s political future spurred market volatility this week, after Italian President Sergio Mattarella vetoed the selection of an anti-euro finance minister and concern grew that Italy could leave the common currency.
Italian bond yields jumped on Tuesday, with the 10-year Italian government bond exceeding the yield on the U.S. 10-year Treasury for the first time in about a year. Meanwhile, U.S. stocks dropped on Tuesday—with banking stocks taking the brunt of the sell-off, given their exposure to weakening Italian government bonds—but rebounded on Wednesday.
“Unlike in past periods of crisis in Europe, there is no broadening market-driven contagion” says Jeff Kleintop, Schwab’s Chief Global Investment Strategist. “This was the result of a political decision by the Italian people, and they are getting a do-over with new elections on the horizon. That may limit the market reaction to a knee-jerk response, compared with the prolonged debt crisis of 2011 or the financial crisis of 2008-09.”
An upcoming election campaign could become a de facto vote on remaining in the euro, said Michelle Gibley, Director of International Research at the Schwab Center for Financial Research (SCFR).
“Most Italians don’t want to leave the euro,” Michelle says. “Market reaction in the form of higher bond yields could serve as a warning to voters ahead of the election and act as a constraint on anti-euro populist party results.”
What it could mean for U.S. stocks
U.S. stocks joined the global sell-off on Tuesday, while investors flocked to the safety of Treasury bonds and the U.S. dollar rallied. Adding to prior worries about the loss of global economic momentum were fresh concerns about global credit conditions and implications for holders of global debt.
The S&P 500® Index hit an all-time high in late January this year. It then had its first 10% correction in two years and has been range-bound since the initial low was hit in early February.
“Corrections tend to be processes over time, not moments in time,” says Liz Ann Sonders, Chief Investment Strategist for Schwab. “In the post-WWII era, the median correction has been about 15% over a median of 153 calendar days.”
The outlook for bonds
Meanwhile, long-term bond yields dropped as investors moved to safe-haven investments. At 2.86% as of Wednesday’s close, the 10-year Treasury yield was down more than 30 basis points in less than two weeks.
There are factors that could lead to higher U.S. yields, like rising inflation and an increasing supply of Treasury bonds, which tend to weigh on bond prices, which move inversely to yields. However, yields may remain depressed in the near term if volatility remains elevated, says SCFR Fixed Income Strategist Collin Martin.
“Low-quality fixed income investments could suffer in the near term,” Collin says. “Spreads for high-yield and emerging market bonds are still low, meaning there’s likely more room for them to rise than to fall, pulling down their prices.”
The Federal Reserve’s policymaking arm, the Federal Open Market Committee (FOMC), is scheduled to meet June 12-13, and is still generally expected to raise short-term interest rates again, Collin says.
“According to Bloomberg, the implied probability of a June rate hike is still 100%, although the implied rate from federal funds futures contracts has dipped modestly,” Collin says. “We still expect the FOMC to continue with its gradual pace of rate increases, although uncertainty in Europe, if prolonged, could slow down the pace of hikes.”
The takeaway for long-term investors
Bouts of volatility may be a good time to revisit your financial plan, says Anthony Davidow, Alternative Beta and Asset Allocation Strategist at SCFR.
“For long-term goals, short-volatility matters less than a diversified portfolio and time in the market,” Anthony says. “For short-term goals, investors may choose to reduce risk.”
During periods of volatility, investors may choose to rebalance back to their long-term strategic asset allocations and revisit their risk tolerance, Anthony says. “Investors often feel differently about their risk tolerance during periods of uncertainty,” he says.
The takeaway for traders
Driven by geopolitical events—mostly in Italy and to a lesser extent in Spain—the Chicago Board Options Exchange Volatility Index (VIX) jumped more than five full points on Tuesday. With an intraday high above 18, Tuesday’s spike was a four-week high for the VIX.
“Ever since the S&P 500 broke through its 50-day simple moving average (SMA) about three weeks ago, it had been re-establishing the long-term trend line, which connected a series of higher lows going all the way back to the end of the last correction in February 2016,” says Randy Frederick, Vice President of Trading and Derivatives at SCFR. “Should that trajectory continue, the S&P 500 Index may be on track to reach a new high sometime in late Q2 or early Q3.”
After Tuesday’s downturn, a quick recovery was needed to maintain that trend and counteract seasonal pressure to “sell in May and go away,” which sometimes occurs around the Memorial Day holiday, Randy says. Traders watching the 50-day SMA of 2672 as a potential technical support level in the near term, were probably relieved by Wednesday’s bounce-back.
At current market levels a VIX of 17 implies an expectation of 24-point swings—in both directions—in the S&P 500 Index, and the abrupt turnaround on Wednesday was just the most recent example
“As seasonal patterns and the relatively recent European geopolitical tensions add to concerns over existing tensions with North Korea and China, traders should exercise patience and wait for lower volatility and a new uptrend to be established before they consider adding equity exposure,” Randy says. While Wednesday’s action was encouraging, a single day does not make a trend.
What You Can Do Next
- Focus on the long-term. If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the noise and focus on your long-term goals. Market volatility is unnerving, but it’s a normal—and normally short-lived—part of investing.
- Learn more. Read and watch Schwab’s experts discuss strategies for weathering market volatility.
- Talk to us. Schwab is happy to discuss your portfolio whenever and wherever it’s convenient for you.
- Call Schwab Customer Service at 800-355-2162.
- Find a branch or a consultant near you.
- Consider Schwab Intelligent Advisory™—our automated portfolio technology with professional guidance. You can schedule a complimentary consultation with a Certified Financial Planner™ professional (CFP®) who can help you plan for retirement, college and future market volatility. To begin that process, fill out this online questionnaire.