Topic/Theme Reports

Country Risk Commentary: Mama Mia, Renzi Arrivederci!

Scott MacDonald, PhD

December 6, 2016

“When you have expectations, you are setting yourself up for disappointment”.

Ryan Reynolds


Summary:  The Italian referendum has come and gone – and so has Italian Prime Minister Matteo Renzi, whose reform referendum suffered a major rejection at the polls. Close to 60% of Italians said No to proposed changes that would have reduced the power of the Senate and streamlined the legislative process to move ahead on badly needed economic reforms. Although the downfall of the Renzi administration leaves the third largest debtor among advanced economies without a government and the country’s banks are in a precarious position, investors took it in stride, drawing greater comfort with the promise of fiscal stimulus from the soon-to-be in office Trump administration.  Another contributing factor was that opinion polls this time proved to be relatively accurate, thus not giving markets another nasty surprise. In response, U.S. stock markets were up and the VIX fell to a little over 12, indicating that risk is down. While we enjoy rising markets, there remains a considerable amount of risk – Italy’s problems are just starting, Donald Trump still hasn’t fully formed his government and will not be in office until January 20th, and Europe has a heavy election schedule in 2017. Voters will go to the polls in Italy, France, the Netherlands and Germany.  It is hard to believe that it will all be smooth sailing.  Indeed, EU bonds got hit hard indicating that somebody is worried. Enjoy the upward movement in equities will it lasts (which could be into early 2017).


Markets by the Numbers (at close of business December 5, 2016)

VIX: 12.14

Crude Oil: $51.15

10-Yr Treasury Bond: 2.387%

Gold: $1,169.70

Silver: $16.73

EUR/USD: 1.0754

USD/JPY: 113.898


Italy - And Now for Something Completely Different?  Matteo Renzi made a gallant effort to restructure Italian politics and reduce its inherent instability, thus setting the stage for badly needed economic reforms.  He was thwarted by a combination of right-left forces, regional resistance to what was correctly perceived as a centralization of power in Rome, and a degree of anti-EU sentiment.  Since 1945 Italy has had 65 different prime ministers, not a great track record and certainly a difficult environment for economic policymakers.  


What is called for is both economic and political reform; sadly this does not appear to be on the menu any time soon.  Instead Italy faces the likelihood of an interim government and elections early in 2017.  Even then it is not clear who will form the next government. The big winner of the December vote is Beppe Grillo, the leader of the populist Five Star Movement.  A former comedian, Grillo wants another referendum to pull Italy out of the Eurozone, an end to EU-mandated government spending limits, income guarantees for all citizens, and possibly a default on the country’s massive euro 2.3 trillion public sector debt burden (equal to 135% of GDP).


In recent opinion polls, the Five Star Movement is just behind Renzi’s Democratic Party, which indicates that Grillo could win enough seats to lead the next government in Italy. Such a development would certainly be a major shakeup in European politics as it would put an anti-eurozone populist at the helm of the eurozone’s third largest economy.  Much will depend on what happens next in Italy, both politically and economically. Although a Five Star Movement victory remains a big if at this point, chances have improved for a Prime Minister Grillo.    


The problem for Italy’s political class, which largely rallied against Renzi, is that the country’s economy is a mess.  At least Renzi was seeking to address pressing issues. Now the opposition – the Five Star Movement, Forza Italia, and the Northern League - have an opportunity to advance something different. But will they?  Moreover, they are running out of time as the economy has generally stagnated over the past 15 years, unemployment remains stubbornly over 11% and the banks are in dire shape. As Alan McQuaid, Chief Economist for Merrion Stockbrokers in Dublin observed: “The collapse of Matteo Renzi's government comes at a bad time for Italian lenders, which are collectively creaking with €350bn of bad and doubtful loans.”


One of the big questions is what will the next government do with its troubled banks, most of which could use more capitalization.  Banca Monte dei Paschi di Siena (MPS), one of the country’s largest banks, is a real worry. In the July stress test by the European Banking Authority it was ranked the weakest of the 51 European banks subjected to the annual assessment. MPS probably needs an additional €5billion to stay afloat.  At the same time, the country’s largest bank, Unicredito needs to raise as much as €13 billion as do two other smaller banks, Banca Popolare di Vicenza and Veneto Banca.


The challenge for the next government is obviously to deal with the banks. That means playing hardball politics with Brussels, where new banking regulations stress a bail-in of stock and debt holders as opposed to taxpayers. If Brussels (read Germany) is strict about this, an interim Italian government would find itself caught between German strictness about the rules and an angry public, many of whom hold Italian bank bonds as part of their retirement plans. This raises very tough questions in Italy over political will. If EU rules are followed (which we do not think they will be to the letter), the risk is that anti-EU sentiment would certainly rise and play into the hands of the Five Star Movement. That, in turn, raises the risks of a new referendum in Italy to leave the Eurozone.


While global stock markets are riding high, Italy’s opposition is celebrating a victory over Renzi and the VIX is flashing little risk ahead, Europe’s next big crisis is already lining up and when it explodes the ripples will be felt far and wide.  Urgent action is needed on the economic and financial fronts, but it is difficult to see anyone assuming a leadership role with any idea of what to do next.


Beyond Italy, Austria did provide a little bit of a respite for beleaguered pro-EU types. On Sunday as Italians went to the polls so did Austrians in a second round presidential contest. Center-left politician Alexander Van der Bellen soundly defeated the far-right Freedom Party candidate Norbert Hofer, 54% to 46%.  While Europe’s liberals were encouraged, it should escape no one that 46% of Austria’s favor a stronger form of nationalism, feel betrayed by the old liberal political order, and have deep concerns over immigration.  Austria, located in the heart of Europe, came close to electing a far right leader. 

Other items to consider – next week’s Fed meeting will see a 25bps hike and the stage has been set for two more hikes in 2017 – dependent of course on data (and how successful the incoming Trump administration will be in getting a fiscal stimulus package through Congress). U.S. economic data remains supportive on a hike – the ISM Services Index for November increased 2.4 points to 57.2. This is the highest level since October 2015 and shows growth in the service sector for the 82nd consecutive month.

The good news on services PMI was also evident in the world’s second largest economy, China. According to the Caixin China Services PMI, services were up 0.7 points to 53.1 in the month of November. Last week the Caixin China Manufacturing Index fell -0.3 point to 50.9, still out of recession but something that needs to be watched.

One last item to report – watch Trump’s China policy. The President Elect is clearly tweaking China, serving them notice that a new leader will be in the White House next year, one who is willing to make changes in the nature of the trade relationship with an eye to reducing the +$300 billion trade deficit with the Asian country.  Trump’s chat with Taiwan’s president is part of what could be a sweeping re-direction of US policy vis-à-vis Asia, China in particular. That realignment in policy will highlight the relationships that best serve Washington’s strategic goals of economic growth and homeland security. The approach is more transactional and outliers like the Philippines will see their importance and support diminish. China can bear the brunt of this or it can opt to sit down and talk seriously about the structural imbalance in trade relations.  This could be a very bumpy ride, considering global supply lines – the costs of a potential trade war could be borne by US consumers (who will ultimately pay for the higher costs of goods made in the U.S.) and U.S. debt holders.  Looking into 2017 Sino-American relations are likely to be one of the major issues guiding markets. 

Top 5 Major Foreign Holders of Treasury Securities (in billions of US$)


Sept. 2016

Aug 2016

Jul 2016

Sept 2015

1. China





2. Japan





3. Ireland





4. Cayman Islands





5. Brazil





Source: Department of the Treasury/Federal Reserve Board

November 16, 2016.

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