All Roads Lead to Rome ...
May was quite a strong month for US stocks. The US indices outpaced foreign stocks, driven by a rebound in the information technology and industrial sectors. Consumer staples and defensive sectors continued to trail on the year. Growth outperformed Value/dividend-oriented stocks.
The US currency strengthened, penalizing Emerging Market stocks and bonds, especially from those countries with large foreign currency debt balances. At the same time, crude oil weakened after a very strong run year-to-date. Bond yields were stable, with the 10 year US Treasury yields closing at 2.85% after a brief visit above 3.1%. The strength in the US markets is imputed to improved expectations for Q2 US GDP growth and positive earning revisions by analysts.
In a recent interview, Jamie Dimon, the CEO of JPMorgan Chase, said that we are probably in the "sixth inning" of the economic recovery and that a renewed "growth acceleration" may be in the cards. Two issues may spoil the party: 1) the rising trade tensions 2) the flare-up in the Italian debt markets.
Rising Global Trade Tensions
Investors aren’t the only ones riled by the administration's announcement it would impose hefty trade tariffs on American allies. “Brussels’ top trade official vowed to respond to Donald Trump’s new tariffs on imports of steel and aluminum from the EU, Canada, and Mexico with measures of its own, and warned that the EU has closed the door on trade talks with the U.S.” The trade spats with the EU and China, if turned into a trade war, are likely to translate into slower global GDP growth and higher inflation. At this point, it is impossible to tell the facts from the rhetoric, but vigilance is warranted.
The Italian Saga
Italy holds many records, among them the number of governments voted into office during its post-war short republican history and the amount of its public debt. To be more precise, the Italian government debt is the third largest in the world (around $2.7 trillion, behind only the US and Japan) and among the highest as a percentage of GDP (132% of GDP) of any developed country. From 2000 to 2016 Italy was one of the few countries to experience a per-capita GDP contraction.
On March 4, 2018, a general election was held in Italy. The results were largely inconclusive. No political party obtained enough votes to achieve a parliamentary majority. Two fringe anti-establishment groups won the highest percentage of the votes: the Five Star Movement, a web-based, anti-immigrant and anti-Europe movement started by a comedian (Beppe Grillo), and the League, a right wing political party formerly advocating Italy's northern regions secession.
These two groups recently formed a government lead by Giuseppe Conte. The financial markets reacted very negatively to this development. As recently as May 15, 2018, the 2-year Italian Government bond yields were negative, and by May 28 they were above 2.7%. The very sharp increase in Italian yields coincided with a remarkable decline in German and US government bond yields, of -0.4%. The anti-European credentials of the new Italian executive branch are rekindling the fears of a disorderly exit of some countries from the Euro.
Why Italy Matters so Much
A highly indebted country can sustain its government debt only as long as a) its economy grows at a faster pace than its interest rates b) the country has its own currency/central bank and can, in case of emergency, monetize its debt. Neither conditions apply to Italy. The Italian economy has been anemic for the greatest part of this century and, as a member of the Euro bloc, the country is at the mercy of the European Central Bank (ECB).
The recent political developments may escalate the problems. The Conte government has promised to both implement policies that will sharply increase the country's budget deficits and to fight the European Union and ECB. The ensuing loss of confidence may push Italian interest rates noticeably higher and force the country into insolvency, especially in light of Italy's bond refinancing needs (see Graph 2).
To further aggravate the situation, ECB's President term is up in 2019. The European central bank is currently led by the skillful Italian professor Mario Draghi, who fought hard to introduce a sovereign bond buying program. As he is replaced, so may be the desire to support the weaker European countries.
How does the above affect global financial markets? Luckily, the majority of Italy's debt is held by retail Italian investors and local financial institutions/insurance companies. Nevertheless, an accidental exit of Italy from the Euro and/or debt default could have far reaching consequences. Most European banks would be affected, the Euro construct would fall apart, and the confidence in the global financial system may vanish very rapidly.
This apocalyptic scenario remains very unlikely. Italy's corporate sector's solvency has improved significantly from the lows in 2011, plus, the vast majority of Italians do not want to exit the single currency, as very recently documented by a Reuters report. The new government may be a blessing in disguise. The popularity of the Five Star Movement and the League is likely to drop sharply. They now have to move on from the easy task of bashing the establishment to running a country. Our money is on the government coalition failing before the country does.
We will continue to monitor the divergence between the yields on the Italian and German government bonds, an effective gauge of a Euro break-up risk (graph 3).
The US economy and corporations are doing well and our main indicators (leading economic indicators, yield curve, credit conditions and market technicals) remain supportive for risky assets. An external shock may cause this scenario to change. The Italian debt problem is one of the main risks overhanging the global financial system. We believe that the likelihood of a Euro break-up and/or Italian default is very limited, but worth observing closely.