Italian Politics Cause a Crazy Market Reaction, by D. R. Barton, Jr.

D.R. photoEight years and three months ago, I wrote an article for this very space about the European debt crisis. Greece was the central problem then and to this day, it remains a sovereign state in debt trouble (though that’s largely been swept under the proverbial rug by a series of “loans” from the European Union).

Greece, however, was not alone in its debt trouble. Back then (wow — was it really more than eight years ago?), the acronym PIIGS was all the rage. It was used to label the debt problems for Portugal, Italy, Ireland, Greece and Spain.

Fast forward to today and many of those same countries have growing populist movements against the European Union — notably Italy and Spain.

The populist movement already struck in England and resulted in the Brexit vote in 2016. In March of this year, anti-EU parties won enough seats in Italian election to form a loose coalition of somewhat aligned populist parties. But it didn’t happen as simply as the Wall Street Journal reports:

“Italian President Sergio Mattarella on Sunday blocked the formation of a Euroskeptic coalition government, raising the prospect of new elections that could strengthen the hand of anti-Eurozone forces.”

Italy is the EU’s third-largest economy behind Germany and France (or fourth, if you count the departing UK) — so this development is a bigger deal with much larger implications than when the 16th largest economy (Greece) was grabbing headlines.

This has brought heightened uncertainty back into the markets and had an impact in some expected ways. But strangely, it has also affected markets and indexes very differently setting up some interesting anomalies.

The Italy Turmoil Fallout in Charts

Let’s start with a few charts where we’d expect geopolitical mayhem to have a big impact. First, the directly affected region — Europe — should have taken a hit, and it did as we see in FEZ, the European analog to the U.S. Dow Jones Index of blue chip stocks:

DR Chart 1
Next, we’d expect the country at the center of the storm, Italy, to take an even bigger hit and it did not disappoint:
DR Chart 2
The opposite — a big up day — should have happened for “flight to quality” assets and indeed it did. We saw a huge jump in U.S. Treasuries, represented here by the ETF TLT:
DR Chart 2
The flight to quality also happened with the Japanese Yen, Swiss Franc, and US Dollar all jumping up. The USD continued its six-week climb:
DR Chart 2
A stronger dollar, however, is bad news for countries with large debt loads denominated in dollars like the emerging markets in general and Latin America in particular:
DR Chart 2
So far, the price moves in the charts we have seen have been unsurprising. Now, let’s take a quick look at a more unusual picture starting with the U.S. Equity Indexes where we see some strange (and perhaps telling) anomalies. First to blue chips where on Tuesday, the Dow broke down below its tight 2 ½ week trading range:
DR Chart 2
And we get similar behavior from the broader S&P 500 big cap index albeit from an even tighter box:
DR Chart 2
As we look at the more “risk on” assets in the Nasdaq tech index and the Russell 2000 small cap index, things start to get much more interesting. The tech heavy Nasdaq basically said, “Ho Hum — what trouble in Italy?”:
DR Chart 2
The Russell 2000 small cap index continued its recent outperformance and was hardly down on the day when all was said and done yesterday:
DR Chart 2

In a traditional worried market — we would expect the Dow and the S&P to take smaller losses than the riskier Nasdaq and Russell indexes. That didn’t happen on Tuesday. Big pockets of the market look like they recovered quickly from the news about Italy. In addition, yesterday’s market breadth was only modestly negative — and ended the day not much different from Friday.

How quickly the smoke clears in the S&P will tell a lot about the health of the market and the market’s perception of how big the Ital-leave problem is. Even amidst down energy markets and geopolitical turmoil, the U.S. market still looks pretty darn resilient.

I always love to hear your thoughts and comments — and especially your additional insights(!) — please send them to drbarton “at” vantharp.com

Great trading and God bless you,

D. R. Barton, Jr.

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