Marcuard’s Market update by GaveKal Dragonomics
By Charles Gave
My thesis has for a while been that we are living in an era characterised by the “little man” revolting against the global elite. I explained this idea in May using the perhaps apocryphal tale of a South Pacific island made up of home-loving tree dwellers and more adventurous boat travellers. The point was that the normally laid back people of the trees were stirring from their torpor as shown by the Brexit vote and then Donald Trump’s win in the US presidential election. Last month saw an extension of this trend in France when Francois Fillon—a straight-talking “tree person” if ever there was one—won the first round of the Republican Party’s presidential primary, possibly heralding the biggest shake-up of the French governing system in modern memory.
But before the French people have their say next spring, the event which could properly upend the “people of the boats” will likely unfold in Italy. The trigger may be Sunday’s rejection of the referendum on constitutional change, but the real cause can be seen in an economic situation that is worsening at an alarming pace. The OECD’s leading indicator for Italy is now falling on a YoY basis, which since 2000 has heralded four of five recessions. Also, the spread between Italian 10-year government bonds and their German equivalents has widened, breaking above its 12-month moving average. When these conditions have been satisfied at the same time, Italy has suffered both a recession and a financial crisis.
As I read the consensus, people seem to think a new Italian crisis is likely, but not yet. I would beg to differ. A new Italian crisis is already under way and could get out of control much faster than expected. Consider the fact that the spread between 10-year BTPs and equivalent bunds stands at about 1.8%pp. If Italy were to exit the eurozone, Italian long rates would quickly rise to at least 6% and the new lira would devalue by at least -20% (suggested by purchasing power parity levels), and probably more.
As a result, the total capital loss faced by holders of 10-year zero coupon Italian bonds (expressed in theoretical deutschemarks) would be at least -40%. Less than half of such a loss is covered by the current spread, so the market pricing is clearly off. Hence, it is clear that every half rational holder of Italian bonds should now sell those instruments and instead buy German bonds. Of course, if such a thing happens it will result in the Italian money supply crossing the Alps quicker than a Sudanese refugee ever could, and cause Italian long rates to rocket upwards. The only buyer will be the European Central Bank, which already has 14% of its balance sheet tied up in Italian bonds. Yet even the ECB cannot buy the whole Italian debt, which is the fifth largest in the world. Before that, you can be sure that certain fellows in Germany will get excited and so at a certain point central bank buying will stop, Italian rates will go through the roof and the situation will have become unmanageable.
In fact, even with long rates in Italy at about 2%, the country is already in a debt trap since the rate exceeds the (nominal) growth rate of private sector GDP. As a result, the government budget deficit is likely to soar, as will the unemployment rate. Given this situation, the idea that markets will wait for the post-referendum political game to play out before moving is, in my opinion, bizarre in the extreme. As we have seen recently in the case of both US long rates and the Mexican peso exchange rate, markets can move very quickly when the fundamentals shift.
A good friend of mine, who is also a very good trader, likes to say that if one has to panic, it is best to be the first to do so. Panicking before unavoidable capital controls are established in euroland seems to me to be a very smart idea. Shorting the Italian bond market seems to be an absolute no-brainer. This revolt of the tree people has only just gotten started and Italy definitely looks to be the next domino to fall.
