#12 – Italy… the domino that ignite the next global economic downturn..

As I continue to focus on some of the upheaval and implications of the populism that is sweeping the US and Europe, this briefing will focus on the political risk posed by Italy and the corresponding investment climate.

Economic Landscape

The Italian economy is struggling. Total GDP is still lower today than it was in 2008, pre financial crisis. Italy Government Debt to GDP in 2016 was 132% (the highest it’s ever been), youth unemployment is projected at greater than 40% and Italy experienced an entire year of deflation in 2016, its’ first in 70 years[1]. Contributing to the challenge is a low birth rate (lowest since the state was founded in 1861), and a historic focus on low cost manufacturing that is increasingly being moved to more competitive cost environments (e.g., China). There are large questions of whether Italy’s businesses are keeping pace and innovating with the rest of the world. Enter Italy’s fragile banking system, with more than 331bn in Non-Performing Loans in 2016 (more than 21.4% of loans are bad)[2] and some of the weakest global banks in the world. “As Italy and Europe more broadly struggle to come to grips with an escalating problem with bad loans, a new paper by economists connected to the Center for Economic Policy Research, highlights the extent to which Italy’s main banks — known to be the weakest in the Eurozone in terms of cash reserves — have stepped up their lending to the country’s most troubled companies”[3].

Potential future stresses on the Italian financial system are not unforeseeable. It was just four years ago when the 2012 Eurozone crisis occurred and Italian CDS spiked to near 700 making the feedback loop between sovereign debt and banking institutions not completely in the rear-view mirror. Do Italy’s political institution’s (and the greater European system) have the capacity and resiliency to weather a future potential banking/debt crisis?

Political Landscape

While the world is watching the drama of the French, German and Dutch election (and processing the after-shocks of Brexit). Italy is dealing with its own unique soap opera that has substantially reduced the political capacity of its governmental institutions to address a fiscal crisis. Matteo Renzi, the young charismatic leader who attempted to pursue through a referendum, was dealt a blow in December 2016 after voters “dismissed his plans for constitutional reform in a crushing referendum that saw close to 60% of voters opt for no”[4]. Renzi would later resign after the referendum loss dismantling his left-right coalition. While Italy attempts to pick up the pieces, Sergio Mattarella, the current president, is facing calls to have an early election well in advance of the planned May 2018 date. Recently, Italy’s constitutional court revised parts of law approved by Renzi that raised the chance of early elections this year (which may also result in one-round of voting vs. two rounds). Adding fuel to calls for an early election are Renzi’s Democratic Party and the anti-establishment populist Five Star Movement (M5S). Rising in popularity the M5S now nearly garners 30% of the vote in a mock election, is an increasing force in Italian politics, and is in a virtual dead heat with Renzi’s Democratic Party. Part of the puzzle will be whether the M5S can garner enough votes to offset the requirement to have 40% majority vote (favoring political groups such as PD who are more likely to form a coalition). The M5S has the potential to shake up Italian politics significantly, furthering the populist trends across Europe. While this is going on, there is still a debate of whether Renzi will maintain his positioning with PD (as party lead) after his resignation and whether the traditional political parties will further fragment.

Who is the M5S?[5]

Founded in 2009 by comedian Beppe Grillo and web strategist Gianroberto Casaleggio, the party was based on “the twin ideas of a new form of direct democracy and popular disgust with the political elites,” according to politics professor James Newall. Most of the leadership from the M5S, comes from the left, but it has picked up voters in both directions with voters who are generally disenfranchised with the status quo. The party’s platform is based on five issues: publicly owned water, sustainable (eco-friendly) transport, sustainable development, right to internet access, and environmentalism. The party’s policies don’t fit traditional political parties[6]. It has a flavor of anti-establishment, anti-immigration, pro-green and is overall skeptical of the European Project. Recent successes in the 2013 election, garnered more than 100 seats for the M5S, including the Mayor of Rome. Some of this has not been without growing pains, including 18 resignations and a rocky start for the Mayor of Rome (she has been rocked by a scandal with over 4 resignations).

So what’s the call?

MP5 will win in an early election (one-round of voting) and have enough votes to govern as Italians are seeking a change and are more willing to vote for a change than present circumstances. This will follow populist trends across Europe.

  1. MP5 will win the election and have enough of majority to govern (40%)
  2. MP5 will win the highest percentage of votes but will fall short of a governing %. PD will form a coalition with the right and Renzi will be back in power. This occurs in two rounds of voting. (35%)
  3. PD will win the highest percentage of votes and form a coalition government with the right. This occurs in round of voting (this occurs in the second round). (20%)

 Outcomes (for the most likely scenario and our call)

  • MP5 will pursue an agenda on a wide eclectic range of issues, none of which are focused on fixing governance issues with the Italian governmental system, or addressing the underlying challenges in the banking system.
  • MP5 will underestimate the complexity in governing a large country leading to some rocky steps in the first 100 days of their administration. This will lead to a reduction of market confidence in Italy’s ability to sustain high debt to GDP ratio, and provide private/public solutions to banking system issues.
  • All the while, the ECB and other European governmental actors will have a full plate. Dealing with the fall-out of other European crises (e.g., Brexit, French elections, Greece etc.)

 

Client Implications

Italian asset classes will under-perform broader European countries, as well as other developed countries around the world. Until additional political stability is achieved, many of the necessary solutions to address fundamental economic challenges will not be possible. Other countries in Europe should be explored for investment opportunities.

Supporting Visuals

Presentation1

[1] http://www.tradingeconomics.com/italy/government-debt-to-gdp

[2] http://www.pwc.com/it/it/publications/npl-market.html

[3] https://www.nytimes.com/2016/08/19/business/dealbook/italian-banks-continue-to-lend-to-stagnant-companies-as-debt-pile-mounts.html?_r=0

[4] https://www.theguardian.com/world/live/2016/dec/04/italian-referendum-and-austrian-presidential-election-live

[5] http://www.thelocal.it/20161202/what-is-italys-five-star-movement

[6] Ibid.

#6 – Monitoring for Inflation and Trump Economic Indicators

After analyzing and monitoring a couple key indicators (e.g., oil, mortgage rates) that we laid out in the previous post on what a Trump presidency will mean for your personal finances, I am further of the belief, that many of these impacts will be fairly pronounced. To recap some of the biggest near term considerations that may impact your personal finances.

  • Interest rates will rise (and are rising), which will impact the demand for housing prices, which should normalize the  housing market and likely mitigate a housing bubble (less buyers willing to spend $$ on higher interest rates), but challenge’s the overall timing of whether to buy or rent.
  • Money will be spent, and a lot of it. Monitor where these infrastructure projects will be undertaken, and where an additional impact on the real estate market will occur (as a result of new railroads and infrastructure projects)
  • Rising tide of equity prices – driven by infrastructure spending, tax cuts and Trump’s de-regulation agenda (get into equities! and have some exposure)
  • Rising yield curve and impact on Fixed Income investments (reduce allocation in Fixed Income)
  • Monitor appetite of US debt securities (from foreign holders of US debt – e.g., China) (keep an eye on this)
  • Monitor Tax deduction / credit changes and how you can optimize to meet these potential changes

Below is a brief update of those indicators and some analysis to support the above observations.

Figure 1: Update of Inflation Indicators

Reviewing the last year (and namely in the last month) of Inflation Indicators, since Trump was elected we can see a marked increase in the yield curve and change in mortgage rates (3% increase month over month) and the ten year treasury yield curve (up 14%)

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Figure 2: Correlation of Indicators

As Treasury Yield Curves have increased or decreased, Gold has moved in the opposite direction (-.90 strength)

As the Baltic Index has decreased or increased – Crude Oil has followed a similar path (.87 strength)

As you would expect as mortgage rates  increase they are highly correlated with the same direction moves from the Treasury Yield Curve (.92 strength), and a decline in

correlation

Figure 3: Summary of Foreign Holdings of US Debt

holdings-of-us-securities

 

Figure 4: Top Holders of US Debt

China and other countries including Japan continue to trim there US Debt Holdings. Will be key to watching as Trump spends more, whether appetite for US treasuries will change.

top-holders

Source for above data is US Treasury Reporting and Bloomberg.

 

 

#5 – Financial Recommendations to Navigate a Trump Presidency

Like many Americans, I am disappointed in the outcome of the election, and have spent a few days soul searching on how  deeply divided our country is, and how we even got here.  I have spent some time analyzing the rural and urban divide, and the anger that many Americans feel as they are either left behind in the new modern economy, or  feel misrepresented by our status quo government (see blog #1 below). Leaving the social, foreign policy and numerous other challenges we will face aside (brought on by a  Republican Senate, House, Supreme Court and Presidency). I will focus on some pragmatic considerations that we can personally prepare for (from a financial perspective), which I hope you will find useful.

I as many of you know, am a history aficionado, and have spent some researching and thinking about the future uncertain path we are headed down and reflecting on when we have seen this before from previous experiences. Drawing upon US history (e.g., Nixon – inflation of 9% in 1972), and learning’s from the author of intelligent investor (Benjamin Graham, and even as far back as Roman History (e.g., Caesar), we can start to build a understanding of what may happen, and what we can do to prepare for what’s next.

What do we know so far on Trump’s economic policies?

He will cut taxes for businesses (likely a flat rate 15% rate give or take), incentivizing corporations to repatriate cash to the US.
– He will simply the tax code and likely introduce tax breaks for many (including a new child care tax credit)
– He will spend, and spend more – likely on infrastructure projects to stimulate growth
– He loves debt financing, and will more or less ignore the debt limits (subject to moderate/budget hawk Republicans in Congress)
– He will pursue an agenda of deregulation, putting less pressure on banks (from a supervisory and regulatory perspective)
– He will put a great deal of pressure on Federal Reserve Monetary policy – to support the above growth agenda

So what could happen?

– Trump could actually spark some additional near term growth
– Bond prices/yields will jump (reflecting a decline in there value)
– Likely leading to significant deficit growth in the US debt borrowing
– Banks will make more money and will have less supervisory/regulatory pressure and will have more money to lend to consumers and companies
– Inflation becomes more likely, as more money is pumped into the US system, and as consumers expectations rise, so will prices.
– Monetary policy  will try to address these increases (through interest rates raises)
– Leading to a scenario where mortgage rates increase, and the rates the US pays on it’s debt to increases…
– And… the potential for creditors and counterparties that own US debt to not believe that it can be paid back (this will be one to watch, the change in US growth vs. the change in the US deficit and what will win)

So what can you do?

– REITs, Real Estate Investments and TIPs (treasury Inflation Protected Securities) offer natural choices to combat inflation (some may prefer Gold here as another alternative)
– Avoid a heavy weighting of non-inflation protected fixed income investments, increase your exposure to equities, and avoid staying in CASH (as it will devalue relative to the increase in inflation)
– Understand tax deductions and changes to the tax codes in detail. Align your business and personal expense strategies relative to the above changes
– Monitor the 10 year treasury yield curve, oil and gold to monitor inflation / and potential changes to these leading indicators
– Monitor how rating agencies, and creditors are viewing US debt (and whether it still be viewed as credible as time)

A few charts I will leave you with that will frame already what’s happened in the last few weeks.

Source: US treasury as of 11/1/2016 and Nasdaq Crude and Gold Prices

A review of inflation forward looking indicators (Treasuries, oil and gold), yields the following insights (somewhat mixed)

  • 10 year treasury yields have just reached 2015 highs (at 2.15%)  in nearly 7 days!
  • Yet Oil and Gold are dropping likely reflecting a “risk on” trade as investors seek equities

 

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goldoil

 

 

 

#2 – An uncertain way forward, Brexit and what’s next

As I wrote in my first post in May of 2016, I predicted a major transformative economic/political event was on the horizon for Europe; whether it was Grexit, Brexit or some other crisis – the foundation of the European Union would be tested in the near future. While Brexit surprised many – it was only a matter of time for one of these make or break moments to actually occur. For those that are in shock or still mired in a state of disbelief, are still likely underestimating the rising swell of discontent amongst the “have nots” and those that are not participating in the new economy. Political parties and citizens are becoming increasingly polarized and extreme.  This is the start and not the end,  the fear of immigration and outsiders is on the rise. The Trump vote is a real global phenomenon that should not be underestimated.

While analysts and scholars debate what’s the most likely outcome for the UK (e.g., whether the UK will pursue a Norway/Swiss solution to working with the EU – or be treated as a third party country), and as such the damage and next steps will becoming clearer; I think we should be a lot more focused on what’s happening in Italy. As I think the EU actually is worse off as a result of this than the UK, and the underlying question of the EU will survive – is going to come into focus a lot sooner than people think. The UK will eventually sort through the mess they made, and although London will be diminished in it’s standing as a business friendly financial hub, it will survive.

The Financial Times reported on Sunday July 3rd, that Italy was prepared to unilaterally pump billions of euros into its troubled banking system if it comes under severe systematic distress. As we discussed in the first blog post, many of the factors for the previous Euro zone crisis have not been addressed; namely the feedback loop between sovereign risk and bank risk. Further exacerbating the situation in Italy is:

  • Low growth Eurozone wide (many countries still not back to GDP levels seen pre-crisis), impacting bank’s growth prospects
  • Negative interest rates, compressing bank return’s on core banking products
  • Total of 400 billion euros of Non-Performing Loans across large Italian banks
  • Rising political instability – due to referendum on constitutional reform (if Renzi – the current PM loses the vote and resigns- significant instability will introduce )
  • Confidence in the Italian banking system is wavering, and the capitalization levels lag large US and EU peers
  • Brexit only hurts these banks further

Let’s look at what’s developed – this is as of July 1st (source: Yahoo Finance / Bloomberg)

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Large Italian banks are getting hammered, when we take a closer look at what’s changed from April to July. Stock prices are on average across the top 5 Italian banks are down 32%, and CDS has risen 13%. Take a closer look at Unicredit, which is the only Italian large globally systemically important banks (G-SIBs). Down more than 42% (at a price of 1.92 a share).

While the news cycle will be focused on next steps of Brexit. Look deeper at some of the other dark clouds on the horizon..