Markets are mixed amid short-term volatility (thanks, Italy) and U.S. economic strength

Brian Nick, Chief Investment Strategist, TIAA Investments

The past week’s market highlights:

A political crisis in Italy is averted as a new government is sworn in on Friday. Eurozone stocks rally on the news but still lose ground for the week. In our view, markets overreacted to the political turmoil, which was driven by the nascent populist government’s attempt to appoint a “euro skeptic” as finance minister. This set off alarm bells that “Quitaly” or “Italeave” would become the new Grexit. While Italians are frustrated with the country’s lack of economic progress, leaving the euro would likely create more problems than it would solve.
Meanwhile, the S&P 500 Index finishes the week with a modest gain. U.S. equities get a boost from a stronger-than-expected May jobs report, robust consumer spending, and upbeat manufacturing data. Investors seemed to shrug off global trade concerns that resurfaced late in the week, when previously announced U.S. tariffs on steel and aluminum went into effect.
The economy shows no signs of overheating, despite its positive momentum. Measured by the Federal Reserve’s preferred inflation gauge—the PCE Index—inflation rose 2% in April compared to a year ago. Stripping out food and energy costs, core inflation increased 1.8%. Both figures were unchanged from March.
Amid a flight to quality spurred by the uncertainty in Italy, the yield on the 10-year Treasury plunged 16 basis points (0.16%), to 2.77%, on May 29. The 10-year note clawed its way back to 2.89% on June 1, just below where it began the week.

Quote of the week:

"You may have the universe if I may have Italy." - Giuseppe Verdi, Italian composer

Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q2 Outlook:

U.S. economy: Late cycle has arrived.
Global economy: There’s still good news out there.
Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
Fixed income: Bond markets offer few places to run, even fewer places to hide.
Equities: The bull market’s not over, but expect plenty more volatility.
Asset allocation: Valuations are no longer at extremes.

**After Italy’s dramma politico, a collective sigh of relief**

Markets overreacted to Italian political turmoil last week. Controversy flared when the populist Lega and Five Star Movement parties attempted to appoint a “euro skeptic” as finance minister—setting off alarm bells that “Quitaly” or “Italeave” would become the new Grexit. Indeed, the markets’ knee-jerk response seemingly priced in the worst-case scenario, reminiscent of events that took place during the 2011-2012 European debt crisis.

On May 29, fears of a euro exit and a ballooning of Italy’s fiscal debt drove yields on the country’s 2-year notes up by 148 basis points (+1.48%), the largest one-day jump in 25 years. While 10-year yields also rose, their move was more moderate. Among Italian equities, bank stocks suffered the most last week, with the FTSE Italia All Share Banks index plunging by 11% between May 28 and 29 before recovering later in the week. The euro also fell, declining by 1.76% versus the U.S. dollar midweek. Equity and fixed-income markets around the world weren’t immune to losses, as major U.S. and global indexes tumbled on May 29 amid the unwelcome political uncertainty.

Fortunately, the market upheaval was short-lived, and with good reason. First, the prospect of Italy exiting the euro is extremely unlikely. Italians rather like being in the Eurozone (two recent polls put public approval of the euro at 60% and 72%). Even the most strident populist politician, once in office, would be loath to seriously consider moving back to the lira, Italy’s former currency, knowing the financial calamity that would ensue. While Italians are frustrated with their lack of economic progress, particularly compared to other large Eurozone economies, most seem to understand that abandoning the euro would not magically solve the country’s problems.

Moreover, after rejecting the populists’ first attempt to install a euro skeptic, Italian president Sergio Mattarella confirmed a less extreme bench of ministers on May 31. Even if the newly formed government’s policies take Italy further into debt, the U.S. and global economy should remain unscathed. Various degrees of political risk remain in Europe (note the no-confidence vote suffered by Spain’s prime minister last week), but the momentum toward populism has waned a bit. Markets may well be warming up to the likelihood of cooler heads prevailing.

The U.S. economy: Gentlemen, start your engines

After several days of market volatility fueled by events in Italy, investors were hoping for some positive signals from the U.S. economy to end the holiday-shortened week. They got it, too, courtesy of a strong May jobs report.

U.S. employers added 223,000 payrolls, considerably more than the average monthly gain of 191,000 over the previous 12 months through April. There was also encouraging news on the wage front: average hourly earnings rose a better-than-expected 2.7% (year on year). Meanwhile, the unemployment rate edged down to an 18-year low of 3.8%.

The past week's other upbeat data releases included:

The Conference Board's index of consumer confidence rose in May to within a whisker of February's 17-year high.
ISM’s manufacturing gauge reached 58.7, with new orders—a key leading indicator—beating expectations by the widest margin. (Readings above 50 indicate that the manufacturing economy is expanding.)
Personal income increased 0.3% in April, as expected. Consumer spending topped forecasts (+0.6%) in April after an upwardly revised March (+0.5%). Consumers dipped into savings to fund their purchases. The savings rate dropped to 2.8%, only the third time since 2007 that it has fallen below 3%.

With consumer activity in high gear, business investment on the upswing, and government stimulus percolating through the economy, GDP “trackers” now anticipate second-quarter growth ranging from 3.7% to 4.8% (annualized), more than double the first-quarter’s modest 2.2% pace. While we believe a GDP expansion rate of 4%+ in the current quarter isn’t unrealistic, we’re mindful that it’s still early in the period. May data has just started to trickle in, and uncertainty over U.S. trade policy remains.

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.

These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.

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