Which way now for Italian government bonds?

About one year ago the famous Bund/BTP spread was still hovering in the mid-400s. One year hence, and in the midst of arguably one of the most complicated political situations post WWII, this spread has fallen to below 250bps. How do we explain this remarkable performance? For starters, as the previous Italian finance minister said last year, about half the 450bps of spread of mid 2012 was due to Europe’s crisis, and the other half to Italian issues. The European crisis has abated for the time being, while Italy’s politics are as complex as ever and its stock of government debt at all-time high.

If the above weight attribution of the cost of Italian debt is correct, one would be hard pressed to see the investment case for buying BTPs at this time. Given that about 50-80bps of the remaining 250 are to be considered ‘physiological’, the ‘extra spread’ is now only about 170bps. This extra spread is a function of political stability and Debt/GDP. The latter is, as we said, hovering at all-time high well over 100%, with any hope of contraction tied mainly to renewed growth to bring the denominator up. The former, given the volatility of the Berlusconi issues, the continued lack of leadership in the PD and the still large 5-Star movement, is not likely to produce good news in the short term.

In summary, Italian bonds have had a nice ride, but at this time, we would suggest that savvy investors will stay out if not play it from the short side.

Italy, are we nearing the day of reckoning?

Every objective observer knows that until the B problem is solved, one way or the other, Italy’s politics cannot be normal. The facts are that arguably the most voted leader in Italian history has been investigated, indicted, and convicted more times than any common criminal. How much of this is due to his deeds or misdeeds, and how much is it instead due to the politicisation of justice? Nobody really knows, but when last week Italy’s highest court, which is called to rule on the final appeal by Berlusconi on the Mediaset/Film rights case, said that it will issue its ruling on 30th July, i.e. in record time, it didn’t take one to be a PDL pasionaria like Ms Santanché to cry foul. Why is it that rapists and murderers can benefit from the well-known slowness of the Italian justice system, which coupled with a generous statute of limitations, effectively gets many criminals off the hook despite them being convicted by one or two lower courts, while for Berlusconi all dockets are cleared and he ‘enjoys’ a ride on the ‘bus lane’ thus depriving him of the benefits (not the right of course) of getting the statutes of limitations to clear him?

While we wait for the final verdict, Italy is verging on another precipice. It was downgraded again by the rating agencies last week, and its government is certain to collapse should the verdict affirm the lower courts’ convictions. Is this the time to find a political solution, as hard and as indigestible as it can be? Rumours started floating last week of a presidential pardon, which was quickly denied by the Quirinale. The truth is that the only possible solution for Berlusconi, short of a revolution, which is still pretty unlikely, is for the highest court to overturn the previous convictions, thereby discrediting the prosecutors and discouraging further lower convictions. Italians are holding their breath.

Serious doubts about the Merkel’s Cure

Yesterday’s numbers released by Ireland’s Central Statistics Office must not have made pleasant reading for EU fiscal hawks. Ireland, among the first countries to enter a deep fiscal crisis, mostly due to its expensive bank rescue, was held as the poster child of the ‘tough love’ economic policy that the EU imposed on countries such as Ireland, Greece, Portugal, and Spain and Italy to some extent, in return for economic and financial aid. Unlike their southern peers in Greece, the Irish people generally accepted the bitter medicine, and in 2012 it seemed like the medicine had worked, with growth resuming, banks beginning to clean up their property portfolios, and until recently, Irish bond yields continuing to decline.

Unfortunately, things seem to be more complex. The cocktail of higher taxes, lower spending and general fiscal consolidation at the time of economic contraction doesn’t seem to have cured any illness. Lower growth with higher taxes, reduces real tax receipts while at the same time increasing the tax burden, which lowers growth, etc. it’s not clear if there are other cures to the European malaise, i.e. if lower taxes and more spending coupled with temporary relaxation of the “3% rule” would do the trick. It is more likely at this point that a much deeper rethinking of the Euro adventure will need to take place.

Italian renaissance

There are a number of ways to describe economic cycles, which oscillate between expansion and contraction. Some of the best known are for example, a U shape, recession, short stagnation and then quick recovery, or a V Shape, where the recession is immediately followed by strong recovery. There are also W shapes, where after a recession and an apparent recovery there is a double dip. None of these letters really apply to Italy at this juncture. In fact the cycle it has been going through, resembles more a ‘bathtub’.

The advent of the Napolitano-Letta legislature could finally signal an emersion into the other ‘shore’ of the bathtub. This ‘grand coalition’ young government could achieve what Monti wasn’t able to complete, i.e. serious labour market reforms coupled with a sharp reduction in taxation. The key will be to convince Euro-Germany that a temporary relaxation of the 3% golden rule will be a pre-requisite for the return of growth.

Should this happen, investors would be wise to start looking more seriously at Italian opportunities in the distressed credit and real estate sectors, which are still benefitting from historically low rates.

And now for the youth!

Italy’s president Giorgio Napolitano was probably looking forward to his Life Senator office where he would have been able to complete his long political career without much stress. However, following a week that saw the effective demise of Bersani and the PD party, and the ineffective attempts at finding a suitable candidate to succeed Napolitano, the president had to agree to be re-elected for a theoretical new 7-year term that would see him in the middle of his nineties at the end of the second term. After witnessing the resignation of a Pope after 600 years, Italians are now once more witnessing history in the making with the first time a president gets a second term.

However, after being the first president to be re-elected for a second term, Mr Napolitano picked Mr Letta to be the second youngest Prime Minister in history. Mr Letta comes from the ‘right’ wing of the left leaning Democratic Party and certainly has a back corridor connection to Berlusconi through his uncle, Gianni Letta.

Many international investors are asking, ‘what’s going on in Italy?’ In simple terms, Italy is going through a sophisticated ‘Italian spring’. With one out of four voters opting for Grillo, Italians have shown to the politicians that they mean business. The old equilibrium no longer works. Political parties are totally discredited, and the PD has basically imploded. There are now two scenarios in front of Italy. The first one sees Letta succeeding in implementing reforms in labour markets and the election system, which will allow for new elections late next year. The second would see a failure of Mr Letta who could fall on Berlusconi’s legal troubles which could still prompt him to leave the government. This would be a disastrous scenario as it would play straight into Grillo’s hands, who is already beginning to lose support. The next 3 months will be key.

Monti’s botched campaign

Italian PM Monti won over 20% of the votes of the other Italy, that is the Italians that live abroad. There are a number of reasons why nearly one in five of the Italians living abroad voted for Monti while he hardly won one out of ten of the ones living in the peninsula. Some say that given that ‘foreign’ Italians weren’t affected by Monti’s fiscal tightening, and didn’t have to pay taxes on their homes, etc., they had no problem in voting for the statesman that Monti is. True, Monti’s cure was great if you didn’t have to swallow it. But there is also another reason.

A former European politician once famously said ‘we all know what are the best policies to implement, the problem is that none of us knows how to get re-elected once we put them in place.’ A campaign conducted back to back after a painful fiscal tightening was never going to be easy, and Berlusconi, one of the best campaigners in the world knew this well. He kept a low profile until he decided to pull the plug on Monti and started to aggressively attack him, as if his party didn’t vote all of his laws. The professor replied that he didn’t understand Berlusconi’s logic. What the professor didn’t understand was that he was falling straight into Berlusconi’s clever trap. Il cavaliere sensed that he didn’t need to ‘make sense’ to recover his fortunes, he simply needed to make rosy promises to a country that is suffering from ten years of stagnation, and repeated tax hikes.

The same strategy was adopted with different comical variations by Beppe Grillo. You can’t disagree when no details are given. Monti made another mistake during the campaign, after promising to rise to politics; he lowered himself in the personal attacks arena, a playing field much more congenial to Berlusconi than to il Professore…

The Resurgence of the US economy…but don’t imitate Europe’s politics!

Five years after the beginning of the Great Recession, the US economy is beginning to show improvements also in the job market. Economists forecast an acceptable rate of GDP growth coupled with a slow reduction in the rate of unemployment this year. Compare this with Europe, which is due to see the third contraction in five years, and where unemployment continues to edge upwards. There are many reasons why the US is doing so much better than the Europeans.

First of all, the US authorities were quick to admit the problems and aggressive in trying to solve it. Also, they have a central government and a central bank that control fiscal and monetary policies and that don’t need to find a consensus among economies that travel at different speeds and sometimes different directions. In addition, the US are on their way to becoming hydrocarbon exporters, thanks to the clever exploitation of shale gas.

Today, US ports and terminals that were equipped to gasify natural gas imported from abroad are reconverting to liquefy natural gas produced in the US for foreign markets where the price of natural gas trades at a multiple of US market prices. Let us hope that US politics will not imitate Europe’s dysfunctionality with the long and boring battle over the debt ceiling and various sequester.

Markets’ reaction to Italian elections

Whether you think that Italians voted for clowns or not, the election outcome was probably near the worst case scenario for markets. The only worse outcome would have been an outright Berlusconi majority in both houses of parliament. As it happens, after an initial strong drop, markets have taken the election results in stride. This may sound strange, if you consider that one Italian out of four voted for Grillo, ¼ for Berlusconi, ¼ for Bersani, and the balance voted Monti or didn’t vote.

One way to explain this mute reaction is that the situation now is very different than the situation in November 2011. At that time, Italy needed to put in place measure to steer the ship, say at least 90 degrees away from the Berlusconi’s route, and that required action. In early 2013, the situation is very different. Monti’s government steered the ship due north towards quiet waters, and until a new captain changes course, Italy is in a sound route. Given that no government from one party will be able to rule, it is likely that it will take some time for a new government to take office and in any case it will be a coalition that will either include Monti or that will be led by a Monti like technocrat. The markets don’t mind such a solution at all, as in 2013, no news is good news!

When electioneering trumps history

Italy’s former PM Berlusconi was a guest of honour at last Sunday’s opening of a new memorial inaugurated in Milan’s main station where the Milan-Auschwitz trains left with hundreds of Jews who would never come back. At the inauguration Berlusconi tried to distance Italy’s wartime leaders from the Nazi war crimes and implied that apart from the criminal racial laws, Mussolini also did a lot of good things for Italy. There are several issues with this affirmation. First of all, it is true that Mussolini did some good things for Italy, in fact so did Hitler for Germany (emerging from the Weimar hyperinflation depression, for example) or Stalin in the USSR, or indeed every dictator in his time. If they didn’t do anything good, they wouldn’t be around for long. The second issue is that it is historically not correct to say that Mussolini was forced to adopt the racial laws by Nazi Germany. Mussolini did so in 1938 before the alliance with Hitler. Finally, even if many Italians think that during the Duce’s time, trains ran on time, how inappropriate to commend Mussolini on the day of memory of the holocaust while inaugurating a holocaust memorial.

Because Berlusconi is a very smart man, we have to assume that this wasn’t a gaffe, but a thoughtful comment designed to impress the extreme right wing electorate. In so doing, however, he may have alienated even more middle of the roaders who will frown at voting for such a coalition.

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