Here we go again

European politics is back to its old tricks. Just when you thought the Continent was settling down, two governments started disintegrating over a weekend.

A recent market mantra has been the muted effect of politics on asset prices. That always seemed a bit of a stretch, considering the movements in currency markets and the bull-run of US equities set off by a change in US taxes. It could be said that the steady rise in US Treasury yields were driven in large part by this change in the US political environment. Now ructions in Europe have put the “end of politics” claim to bed.

Italian President Sergio Matarella has effectively shut down attempts by far right and left-wing parties to form a broad coalition. Instead he appointed a technocratic leader to guide the country. While this is laudable in terms of competence and sound management, ousting a democratically elected government in a nation that decries its lack of a voice is ill-judged. Mr Mattarella’s technocrat is likely to be ejected in a vote of no confidence and Italy is expected to return to the polls in August. The upheaval flipped a switch in the Italian debt market. The 10-year yield has shot up 70% in May, rising above 3% this week. Its two-year debt has also spiked, with even more venom: it was as high as 2.25% on Tuesday morning (it closed on Monday at 0.87%). Just two weeks ago, short-term Italian debt yields were negative.

A completely dispassionate assessment is that this is how the market should value the debt of a country with the developed world’s second-largest debt to GDP ratio, limited growth and no government. It makes sense for Italian debt to yield more than the US, for instance. However, this episode gives us a little sneak peek into just how much central banks have distorted markets since the global financial crisis. How high would Italian yields be if the European Central Bank wasn’t buying up its debt like a kid in a corner store? And what effect would such borrowing costs have on one of the EU’s largest economies? It can get messy when the European institutions populists are railing against are the only thing holding back the tide of fiscal reality.

Spain is also in disarray after a court ruled that the governing Popular Party had used an illegal slush fund for campaign financing between 1999 and 2005. The judge thought Prime Minister Mariano Rajoy’s denial of all knowledge in the matter was “not credible”. Mr Rajoy now faces a vote of no confidence later this week that has a reasonable chance of putting him out on his ear. Spanish debt has spiked this week too. All this drama sent safe haven bund yields lower along with the euro. The fallout even reached across the Channel, with gilts diving to 1.17% from the 1.40-1.60% range of the past couple of months.

A good guide of investors’ eurozone worries is usually the bund spread – the difference between the yield of Spanish/Italian debt and German debt. However, we think the currency will give a much better handle on how damaging investors expect this affair will be. If the euro continues to sag against the dollar, that would be a bad sign. 

It seems politics still packs a punch in the markets after all.

Source: FE Analytics, data sterling total return to 25 May

Snatch and grab

Brexit is beginning to bite and projections of tax revenue are starting to look a bit iffy, so it’s about time for the UK government to start sniffing round for some extra cash.

An option has suddenly popped up following a report by the independent Office of Tax Simplification (OTS), which advises the Chancellor on better policy. It says the government could align the tax rates for dividends and income, ending the preferential tax treatment of company payouts. If enacted, that would increase the tax bills for many investors, especially the wealthy and the old. It would also hit the self-employed, many of whom find it tax-effective to pay themselves small salaries and large dividends to dodge the taxman.

Moderating tax advantages of the self-employed and the old has been high on the government’s agenda recently. The attempt last year to align self-employed National Insurance payments with those of typical employees crumbled in the face of a populist backlash against the attack on the quintessential “white van man”, despite the fact that the measure was most likely to harm only barristers and consultants. Going after dividends would have a similar effect in levelling an institutionalised tax arbitrage for the self-employed that appears unfair on the surface. But the red tops have likely already lined up bombastic stories about a tax squeeze on hard-up pensioners. It’s likely for this reason that the head of the OTS told the FT that the “radical” proposal was “an outlier”.

Still, it’s unlikely that the government would reduce headline income tax a bit while increasing dividend taxes to a single rate to correct an unfairness. They would simply raise dividend taxes to where income taxes are and take the extra money. The government has already reduced the dividend tax allowance by £3,000 to £2,000 from this year, boosting expected revenue by £870m in 2019/20, £870m in 2020/21 and £930m in 2021/22. Abolishing the allowance altogether and hiking rates would probably bring in even more money again. It would also solve the Frankenstein that is dividend taxation: even HMRC’s computers struggle to calculate the liability properly because of all the allowances, tiered rates and ISA effects. That’s why we think this plan could become more than just an outlier.

Such a plan would have radical effects on many different people though. Especially hard hit would be basic-tax-rate-paying shareholders, who would experience a dramatic increase in their taxes. In the main, people with limited income and high dividends tend to be pensioners. And pensioners tend to be feisty at the ballot box, a dangerous thing for a government with a razor-thin majority to go after.

That’s the thing with politics and policy: they always seem to have unintended consequences.

Bonds

UK 10-Year yield @ 1.32%

US 10-Year yield @ 2.93%

Germany 10-Year yield @ 0.40%

Italy 10-Year yield @ 2.45% (now 3.0%+)

Spain 10-Year yield @ 1.45%

 

Economic data and companies reporting for week commencing 29 May

Tuesday 29 May



UK: Nationwide House Price Index 

EU: M3 Money Supply



Final results: Renold

Quarterly results: Bank of Cyprus



Wednesday 30 May 



US: MBA Mortgage Applications, GDP (Preliminary)

EU: Business Climate Indicator, Consumer Confidence, Economic Sentiment Indicator, Industrial Confidence, Services Confidence; GER: Retail Sales, Unemployment Rate



Final results: Telford Homes

Interim results: Nexus Infrastructure, Oxford Metrics



Thursday 31 May



UK: GFK Consumer Confidence, Consumer Credit, M4 Money Supply

US: Continuing Claims, Initial Jobless Claims, Personal Consumption Expenditures, Personal Income, Personal Spending, Chicago PMI, Pending Homes Sales, Crude Oil Inventories

EU: Consumer Price Index, Unemployment Rate 



Final results: Johnson Matthey

Trading statement: Card Factory



Friday 1 June 



UK: PMI Manufacturing

US: Non-Farm Payrolls, Unemployment Rate, PMI Manufacturing, Construction Spending, ISM Manufacturing, ISM Prices Paid, Auto Sales

EU: PMI Manufacturing; GER: PMI Manufacturing

Julian Chillingworth

Chief Investment Officer

The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance. 



Rathbone Unit Trust Management Limited is authorised and regulated by the Financial Conduct Authority and a member of the IA. A member of the Rathbone Group. Registered office: 8 Finsbury Circus, London, EC2M 7AZ . Registered in England No. 02376568