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 benefiting from historically low rates.

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…

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!

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.

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.

Will he run or will he not

In the following hours, Italy’s parliament should pass the finance bill and after that Monti will go up to the Quirinale hill to resign..  Right after that, it is now looking likely even though not yet certain, that Mr Monti will run for office in the next parliament. What is not sure yet is with whom. Elections will be held in February 2013

If markets are a good barometer, and they usual are so indeed, Monti will run, and if he runs he has a decent chance to replace himself as the next PM. The Bund /BTP spread has gone back down below 300bps and the FTSE Mib is above 16,000.

Even if Mr Monti does run, the next few months will not be a clear ride, and at these levels of spread and MIB, it may make some sense to take some profits…

Strictly for a non-domestic audience

Here we go again…we will all hear a lot more about Berlusconi in the three months ahead. As we wrote last week, Bersani’s victory seems to have tipped the scales for the Cavaliere to “get back into the field,” as he puts it. Everyone agrees that his chances of victory are incredibly slim, but there will be a lot of noise and a lot of volatility between now and February-March, when elections will be held.

It is still likely that the elections will not give a clear winner, with the top 60% of the votes split between the left, the Grillo movement, and the PDL. The only new negative, further to Monti’s resignations, is Monti’s relationship with the PDL. We thought that Berlusconi’s strategy would have seen the PDL proposing Monti v 2.0 as a ‘super partes’ solution post inconclusive elections, but now that Monti resigned because of the sharp criticism he got from Alfano, it is not entirely clear that the PDL will want to or be able to make that suggestion come the spring…

In the meantime, markets will be nervous, and any opinion poll that shows the PDL edging up will be seen as a risk to the EU and Draghi’s strategy. In the end, this could make Italian bonds and equities buying opportunities, since Berlusconi cannot win, but there will be plenty of volatility in the middle.

Monti’s challenge

Just as we discussed last week, Monti has delivered a tough budget which comprises both tax savings and incentives.

The standard narrative in Italy is that the advent of the Euro saved the Italian economy. Three standard reasons are given: the Lira kept on being targeted by speculators and its peg to the ECU and DM had to be devalued on a semi-regular basis; the conditions for joining the club, which were imposed by the Prodi-Amato administration forced Italian finances to become more virtuous; and finally, the lower cost of borrowing would have allowed the budget deficit and the cost of servicing the stock of debt much lower.

Most of the above benefits did indeed take place for most of the previous decade, which saw record low borrowing rates, primary budget surpluses, and a conservative approach to government spending post the Lehman crisis which meant that Italian finances didn’t appreciably deteriorate after 2008, unlike the United States’ and the UK’s, for example.

However,  and counter intuitively, the price paid for these virtues was a transfer of wealth from the productive areas of society which stopped growing as unit labour costs went up in absolute and relative terms and made Italy less competitive, to the ‘rentiers’, which had lower nominal returns on their fixed income portfolios, but enjoyed an incredible appreciation in the value of their real assets. These effects are easily spotted: Italy barely grew in the last decade, as a strong currency made it less competitive vis a vis not only China, but also Germany, but the price of a square meter of prime real estate in Rome and Milan is now in the same league of London and Paris, and certainly higher than Frankfurt and Berlin.

The fair way to deal with this problem, which we understand Mr. Monti  ‘gets’, is to reduce taxation on the productive part of the economy, by lowering payroll taxes, and making the labour market more flexible, and at the same time taxing big property wealth and increasing the pensionable age. These measures would have a combined effect of reducing youth unemployment, reducing unit labour costs, increasing consumption, and ensuring a degree of fairness to the fiscal adjustment which will improve the chances of it being accepted by the nation.

Non Italian investors will be forgiven for getting bored with the B word…

The question seems to be once again, “Will Berlusconi run again for PM after promising he wouldn’t, then saying he was thinking about it, then denying, and then leaking that he might?” And if does run, why would he do it knowing that the only unknown would be how big the loss is going to be?

The answer to the first question is that Bersani’s triumph in the primaries makes it more likely that he will end up running. The answer to the second question is always the same. Berlusconi doesn’t need to win, he needs to stay relevant not only for his legacy, but also to be able to have something to trade against his legal issues, still unresolved. A good result for Berlusconi would see Grillo and Bersani taking votes from each other and a PDL at between 10-20% in third place that would be able to say, let’s keep Monti for the good of Italy, and by the way, sort out the legal cases.

It is surprising that given this cacophony, the Bund BTP spread is down to 300bps or below. Here there may be two answers. The first is that the market sees through the B ploy and likes the idea of a Monti Bis. The second is that markets are now otherwise preoccupied and haven’t reacted yet…in which case, this spread may have seen its lows at least until mid-next year…