Country Risk Commentary: "Italy: No Grazie Referendum, Mangia Debito"
Scott MacDonald, PhD
|November 21, 2016|
"The process of delving into the black abyss is to me the keenest form of fascination." H.P. Lovecraft
Short-term Outlook: While the shape and tone of the incoming Trump administration is the major factor driving markets and certainly media attention, it is hardly alone in influencing markets and the economic policymaking landscape. Europe's political season has started with the field of presidential candidates filling out in France, Chancellor Angela Merkel announcing that she will be going for a fourth term at the helm of the world's fourth largest economy, Germany, and Italy's December 4th referendum is around the corner. We are watching the rise of the US$, which has been up against the yen, euro, and Aussie dollar. Prospects for stronger fiscal stimulus in the U.S. by the incoming Trump administration has pushed the US currency up, which, if sustained (and we see little reason for it not to be), could hurt U.S. exports, raise imports, and reduce revenues for a large spread of American companies. At the same time, it puts pressure on the Federal Reserve to raises raise rates (and yields are already leaking out), which, in turn, will increasingly point to the burden of U.S. public sector debt. Remember rate increases will push up interest repayments.
While we favor the incoming Trump administration's interest in launching a massive infrastructure spending program, there is a growing need for further clarity on how it will be funded. The Trump equity rally looks to be petering out and the carnage in the corporate bond market has subsided. It is always said that the biggest thing markets fear is uncertainty; we see this as a key force through the rest of 2016 and into 2017, especially as December 4th is the Italian referendum and January 20th begins Trump's first 100 days in the White House.
U.S. 10Y Treasury bond: 2.34%
VIX Index: 12.55
Crude Oil: $46.32 (per barrel)
Perhaps the most significant story in the short term is the December 4th Italian referendum. Most recent polls (akin to reading from chicken entrails) give the "no" vote a slight edge. Although Prime Minister Matteo Renzi’s Democratic Party is ahead in polls when Italians are asked which party they would vote for in a general election (around 30%), the populist Five Star Movement is right behind them. The Five Star Movement was created by the comedian and internet populist Beppe Grillo, whose slogan is Vaffa!(f-bomb off) to more or less everything, including the euro. He has dismissed the referendum question as ‘incomprensibile’. A number of Italian analysts believe that the Brexit and Trump victories as well as the rise of populist parties throughout Europe will be a factor in swaying a sizable number of their fellow citizens to vote no - enough to kill the reform motion.
What is in the referendum? Boiled down, the referendum would curtail the powers of the senate, by reducing the number of senators (who would no longer be elected, but appointed by regional governments) from 315 to 100, which would make economic reforms easier to pass. Moreover, the referendum would shift to a version of proportional representation which awards bonus seats in the lower house to any party that gets 40% or more of the popular vote right away — or in a run-off between the two most popular parties. The winning party will thus be guaranteed 340 seats in the lower house, an impregnable majority and able to pass legislation. It would also provide greater political stability to a country that has had over 60 governments since World War II.
While the Five Star Movement is urging their followers to vote no to the referendum, the rump of media tycoon Silvio Berlusconi’s party, Forza Italia, will also vote ‘no’ in the referendum. Also in the no camp is the populist Northern League party, which favors Italy pulling out of the euro and illegal immigrants being forced out of Italy. There are even members of Renzi's own party who are opposed to the reform vote.
Complicating matters for Renzi is the economy. Since 2008, Italy’s GDP declined -8% while the UK’s, for example, has expanded by +8.2%. Italy’s unemployment rate remains stuck at around 12% (youth unemployment is close to 40%). Public debt keeps growing and is now 135% of GDP — the third highest in the world by that measure (only behind Japan and Greece according to the OECD). Rounding off this dismal picture, Italy’s banks (including Monte dei Paschi di Siena) are in deep trouble - they are still under-capitalized and hold €360 billion of bad loans — the equivalent roughly of a fifth of Italy’s GDP.
Consequently, the referendum is not solely about the constitution, but also on Italy's EU membership, the euro and the Renzi government. Reflecting growing unease the spread between Italian government bond yields and German ones is widening due to uncertainty over the referendum outcome. The math is straightforward - the more the spread rises, the more the interest Italy has to pay on its substantial public debt. If the Renzi administration loses the referendum vote, Italian bonds spreads could reach painful levels and indicate rising chances of an Italian default. Although an Italian default is not on the books at this juncture, the country has enormous financing needs and the collapse of the government would greatly complicate an already murky situation.
1. U.S. Politics: The incoming Trump administration will mark a sharp shift to the right in terms of policies. The next U.S. government will look at the world through a more narrow lens of national interests, defined by a small core of people who orbit Donald Trump. While this will appeal to the right wing of the Republican Party, it does little create a balm to the nation's divisions. We think the President has to give weight to more moderate Republicans for posts such as State and Commerce to indicate that he is willing to work with establishment figures in the party. Otherwise he may have tactical issues within own party, which could complicate passing legislation.
2. U.S. Economy: The rising dollar is a potential point of concern. As the Financial Times noted (November 20, 2016): "Still, the dollar rally is impressive and goes beyond recent violent asset allocation shifts between bonds and equities. The dollar index ripped through 100 and then 101 last week to a near 14-year high. It has risen more than 3 per cent since polling day, as investors have dumped EM equities at the highest pace for 14 months." There is a strong chance that the U.S. dollar could remain strong in 2017 - due to the Trump administration's commencing its fiscal stimulus and a large amount of dollars coming back to the U.S. from overseas in a tax deal. This could add to inflation pressures, weigh heavier on U.S. debt management, and complicate the macroeconomic environment in a number of emerging market countries.
3. Italian Referendum: The focus will increasingly be on Italy, its potential for another major political crisis and how this impacts the country's ability to manage its public sector debt/GDP burden of 135% and maintain confidence in its troubled financial system. There is increasing talk of the "Italeave" if Renzi loses and the Five Star Movement is able to force a new election. As we said last week and above, this is the country to worry the most about as a European flashpoint.
4. Brexit: The British government needs to better clarify its plans for Brexit as this is a major uncertainty hanging over the economic and business landscape. The UK Chancellor of the Exchequer Philip Hammond recently announced that its 2017 forecast for real GDP is now forecast at 1.25%-1.50%, down from an earlier forecast of 2.2%. The fiscal deficit is also expected to widen. Questions are also being raised over what impact the incoming Trump administration's trade policy will have on trade between the two countries.
5. Trade Protectionism: Global trade is stalling and the rise of protectionism has an echo of the 1930s. Canada, China, Mexico and Japan are carefully watching the incoming Trump administration's commentary in this area. China has carefully outlined that they want to maintain good trade relations with the U.S., but that they also have means to strike back if Washington opts to go back the 1930s.
6. European Banks: German and Italian have banks that have been in the press over the past year and many of the problems they face in terms of capital adequacy and profitability remain a concern. If Italy spins into a political/economic crisis look to the banks to be highly problematic. And problems could extend to French and Swiss banks, which have sizable exposures to Italy.
7. China's credit bubble: The Chinese government has imposed controls on property development in a number of major cities in an effort to stabilize real estate markets. Despite an effort to dampen these markets, property development investment rose 6.6% from a year earlier in the first ten months, compared to 5.8% over the previous period. Cooling prices and fewer transactions are expected to hurt services, but construction fueled by investment remains key to driving output. We expect that headwinds are likely to remain in the Chinese economy, as property markets in tier-1 cities have started to cool down, which, in turn is likely to result in a cooling in real estate activity in lower-tier cities, which could very well drag property investment growth. Growing problems in property markets throughout China would then be transmitted into the banking/financial system. The banking/financial system remains the potential Achilles heel for the Chinese economy, though we would not look for a crisis to unfold as has happened in the West considering the large state role in the economy.
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