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The Italian Job Shouldn’t Have Been Such a Shock

The good news is that it looks like manufacturing got a bit stronger entering Q2, and consumer spending was slightly better, too. So, Q2’s U.S. GDP may actually be a tad stronger than Q1’s. But, the good news stops there, as the rest of the world, especially Europe, appears to have hit a wall, a barrier that has displayed itself for the last couple of months, but, till now, was ignored.

In several of my past blogs, I have remarked that the talking heads on business television (“bubblevision”) were misleading investors with their view that the equity markets would remain strong because of “synchronized” global growth. It took the likes of Mohammed El-Erian, in a May 29th Tuesday morning interview on CNBC, to convince investors that such “synchronized” growth was in the rear view mirror.

This all came home to roost on Tuesday, May 29th, the day after Memorial Day in the U.S. On Sunday, May 27th, Italy’s President, Sergio Mattarella, blocked the formation of a new government when he rejected 81 year old economist Paolo Savona, who was picked by the coalition of the 5-Star (left) and League (right) parties as their choice for economic minister, an especially important role given Italy’s precarious public finances and weak banking system. Savona is a “Eurosceptic.” That term pretty well conveys what his policies would be toward remaining in the European Union. This likely means new elections in Italy in September, and markets are worried that the two extreme parties (5 Star and League) will emerge with even a larger share of the votes. This, in turn, could possibly mean, at a minimum, fiscal spending that files in the face of EU rules, or, at the extreme, debt repudiation. Italy is the 4th largest economy in the EU and 8th largest in the world. It also is the 8th largest external debtor, meaning it has $2.5 trillion of debt denominated in U.S. dollars. Its banks are also very weak with 11.1% of total loans categorized as non-performing. Contrast that with France (3.1%), the Netherlands (2.2%) and Germany (1.9%). Given such conditions, Italian bank failures could cause further market indigestion.

The result was that, on Tuesday, May 29th, Italy’s ten year government note rose 40 basis points (0.4 percentage points) as markets opened in Europe, and its two year paper bounced an amazing 145 basis points (1.45 percentage points). At the same time, Germany’s ten year government note fell seven basis points and its two year was down 10. Then, when U.S. markets opened, there wasn’t a flight to quality, there was a stampede. The U.S. 10 Year T-Note, whose price had risen quite rapidly over the week ended May 25th, as yields fell from just under 3.10% to 2.95%, duplicated that same feat within the Tuesday trading session, with yields closing under 2.80%. There are still a lot of long-term Treasury short positions outstanding, as market participants had assumed that U.S. longer-term rates would be rising, at least through 2019. So, it is likely that U.S. longer-term rates will continue to move down for the next few weeks. (Retired market guru, Bob Farrell, of Merrill Lynch fame, had a set of 10 Rules for Investors – Rule Number 9 was “When all the experts and forecasts agree – something else is going to happen.” Mr. Farrell was correct yet again!)

Today, it is really hard to believe that, on Friday, May 25th, Italy’s 10 year government bond sold at yields below those of U.S. 10 year T-Notes. The reality is that they did, showing you the extent to which the monetary policies of the world’s major central banks, in this case the European Central Bank (ECB), have distorted markets. (Italy’s paper is rated BBB, while the U.S. is AAA.)

While this feels much like the Greek drama that played out in 2011-2012, the circumstances are dramatically different. Back then, the ECB’s Mario Draghi pledged to do all he could to save the system. According to Wall Street economist David Rosenberg, today, the ECB already owns 15% of the Italian bond market, its maximum permissible amount. So, it would take a significant change in the rules for the ECB to support that market further. As Rosenberg has quipped more than once, “Italy is too big to fail, but it may also be too big to save.”

Besides Italy, Spain, too, has political issues. Its current Prime Minister, Rajoy, faces a no-confidence vote as 29 people linked to his political party were convicted of crimes including influence-peddling and falsifying accounts. This just adds to the financial angst emanating from this part of the world.
Getting back to the synchronized global growth story, the currencies of Argentina, Turkey, and Indonesia, all countries with large dollar denominated debt, have been hard hit by the rising value of the U.S. dollar. And the European caused flight to quality (to U.S. dollars) has only served to exacerbate this situation. Impacts are also being felt by the Brazilian Real, the Russian Ruble, and the So. African Rand. All of these countries have large external (U.S. dollar denominated) debt, and the rising value of the dollar makes it harder for them to service that debt. In the extreme, rising rates can throw those countries’ economies into recession. At the very least, it will significantly slow their growth. Already we are seeing this in the downturn in the Baltic Dry Index (shipping).

According to Bloomberg, $250 billion of emerging market debt needs to be refinanced over the next 19 months (through the end of 2019). The stress is such that, for the first time in 13 years, emerging market bond yields are higher than U.S. high yield (junk) debt.

So much for the “synchronized” global growth story. Of course, now that the cat is out of the bag, and the “synchronized” growth myth has been revealed for what it is, equity markets took it on the chin. The Dow fell nearly 400 points on Tuesday, May 29th, more than 1.5%. Could it be that the stronger dollar and slowing international growth will negatively impact multinational revenues and earnings in the foreseeable future?

Robert Barone, Ph.D.

Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).


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