Apparently all is not lost
No Maginot line has been crossed
But Italy’s still
Devoid of goodwill
And markets will be turned and tossed
The acute fears felt in markets yesterday morning have abated somewhat today. While nothing has really changed in Italy, which has been the epicenter of the current crisis, the tone of the commentary has been softened. As in all politics, the initial disagreement is always loud and abrupt as each side tries to rally its supporters, but in the end, a compromise is usually reached. At least that has been the pattern during the post WWII era. Of course, during the past two years, arguably ever since the Brexit vote, that pattern has been called into question.
My contention is that during the past 75ish years, there has been a tacit bargain between politicians of all stripes and their constituent populations as follows: most people don’t really care that much about politics, nor about who leads their country. They are far more concerned with their personal situation seeking mostly to earn a decent living, take care of their family, go on vacation periodically, and perhaps most importantly, believe that their children’s lives will be as good or better than theirs. While there are certainly single issue voters, who care deeply about a particular subject (think pro or anti-abortion, pro or anti–gun restrictions, etc.), the bulk of the population just doesn’t care that much. This situation is why it is rare, at least in the US, for one political party to win more than two presidential elections in a row; people just get tired of one party trying to do too much and are willing to change things around. And while there have been recessions during this period, they tended to be pretty short-lived and so were not sufficient to alter the big bargain, which could be stated as: we don’t care who wins political office as long as our lives are reasonable. Don’t take too much in taxes and give us a chance to believe things will get better and we are ok.
But then came the financial crisis in 2008-9. The subsequent recovery has been so anemic around the world that after six or seven years, broad sentiment started to change. People looked around and saw that the political classes were not doing simply ok, but were thriving, yet their own circumstances were not improving much at all. At least that was the perception. And it is this change in view that has led to the upheavals in politics that we have witnessed since June 2016, when the UK voted to exit the EU. Antiestablishment candidates and parties have performed extremely well since then, with the Italian elections in March simply the latest manifestation of that situation. The question, at this point, is really about just how far each of these parties is willing or able to push their agenda. And it will differ in each country. So is Italy going to be the straw that breaks the camel’s back? Is this the time when one of the major post WWII institutions, which have been under attack before, finally succumbs to the populist vote?
My view is that the odds are much higher than ever before. Remember, even though the UK left the EU, the EU remains intact and is fighting fiercely to show why it is still relevant. But if Italy were to become Quitaly and leave the Eurozone, it is not clear that the euro would be able to survive the blow. And given that a new election in Italy seems destined by September, and the antiestablishment parties now command ~60% support in the polls, it is entirely possible that bigger things are coming.
Consider the financial repercussions that would occur in this event. Redenomination of Italian euro debt to lire debt would have a devastating impact on the entire Eurozone banking sector, as well as the ECB, which is the largest holder of that debt. All the money that Italy has borrowed from the rest of the Eurozone, its so-called Target2 balances, would be called into question as to its likely repayment. While Italian yields would skyrocket, they would almost certainly repudiate a large chunk of debt (they’ve done it multiple times in their history). The new lire would certainly tumble, but that would have the salutary effect of supporting their export industries. And while inflation would surely rise sharply, it is not hard to believe that the country would be able to recover relatively quickly without the strictures of German fiscal prudence holding them back.
Meanwhile, the euro would likely fall sharply to begin with, but eventually, it should recover. After all, if one of its weakest links were to leave, the remaining countries would represent a stronger bloc. But the one thing that is certain is that markets would be disrupted across the board for at least a few weeks, and possibly longer, as investors tried to figure out what would come next. Yesterday was a little foretaste of what might happen in the event of Quitaly. But it would be a much bigger impact.
However, they are not leaving today, and in fact, the market is far more sanguine that they will not do so at all. Italian bonds have recovered some of yesterday’s losses, while Treasuries and Bunds have both sold off a bit. The dollar has fallen pretty substantially against most currencies, with SEK (+1.35%) actually leading the way in the G10 while the euro has rebounded 0.8%. EMG currencies have also performed well this morning, led by ZAR (+1.1%) and HUF (+1.25%). Given the enormous volatility we have seen in TRY lately, its 1.8% rise seems merely ordinary. Equity markets have rebounded somewhat, with Italy’s MIB leading the way at +2.2%, but the DAX (+0.5%) also showing some spirit. (US futures are little changed at this point.) In other words, yesterday’s risk-off scenario has been unwound to some extent. It seems that the ‘buy the dip’ mentality continues to be a key driver in markets.
While there are many other things that ordinarily would have had an impact on markets (increased discussion of US tariffs, a rate hike in Indonesia, oil’s sharp price decline to name just three), that is not the market’s focus right now. That information will need to be assimilated going forward, but seems unlikely to drive a large price move. Of course, that is until those tariffs are imposed, or OPEC announces a change in policy, or something else happens and Italy drifts into the background. But that, too, is unlikely today.
Rather, looking ahead to this morning we see ADP Employment (exp 187K) and the second estimate for Q1 GDP (exp 2.2%, down from 2.3% initially). Later this afternoon comes the Fed’s Beige Book, which seems likely to continue to show US economic strength. Yesterday saw Case-Shiller Housing prices continuing to advance at a 6.7% clip while Consumer Confidence remains buoyant with a reading of 128.0, up from 125.6 last month. The point is that the data is not driving markets, the story is. If the story continues to evolve where 5-Star and the League in Italy moderate their demands, then we will head back to a data focused market, but that will take a few more days to get market participants to believe it, so my guess is that we remain hostage to Luigi De Maio and Matteo Salvini, the leaders of those two parties for the time being.