The View from Germany

Press rumours are speculating about the creation of a wider rift between the head of the ECB, Mario Draghi, and Mr.Weidmann, the formal Merkel advisor currently head of the Bundesbank. Whatever the specific motives of the alleged breakdown in their relationship, this personal issue has wider ECB and pan European implications. Simply put, France, Italy and the other weaker EU countries believe that without fiscal stimulus there is no getting out of this painful and prolonged recession. Draghi has done ‘all he could’ with conventional monetary policy and now, in the absence of fiscal stimulus which is constrained by the EU budget rules (i.e. to stay within 3% limit), is beginning to do, at least in Germany’s view, more than he should.

Renzi and Valls’ point of view is widely known: too much continued austerity is killing the patient. They argue that now that both France and Italy have governments which appear serious on reforming, they should be given the slack to enact countercyclical measures that will result in a widening of budget deficits in the short term, but in a sustained recovery in the medium term.

The problem is Germany has seen all of this before, and from their point of view, they need to see real action on the ground of labour reforms, spending cuts, etc. before agreeing to any more stimulus measures. With regards to the unconventional monetary policy steps that Draghi is beginning to embark upon, the Germans are not happy at all. Rock bottom interest rates, negative in certain instances, are hurting both savers and corporates; the idea of the ECB starting to buy structured products is equally scary to them.

As always, the solution will have to be political. France and Italy will have to do more real action on the ground to nudge Germany to reluctantly agree to fiscal stimulus such as widening budget deficits…most will agree that monetary policy has done all it could in this cycle.

Putin, ISIS and the Central Bankers

You wouldn’t necessarily think that Ms. Yellen and Mario Draghi could be a good match for Putin and the Islamic State thugs, but incredible things are happening in the markets.

The geopolitical situation in Europe is as at least as bad as at the time of the Soviet-Afghanistan war: Russia and Ukraine are at war, the Arab world is upside down, from Libya to Egypt, from Syria to Afghanistan, even ignoring little Gaza, the situation is literally explosive. Old strongmen have been replaced by bloodthirsty fanatics with huge resources and even larger ambitions.

In the middle of this mayhem, you would expect the markets to worry, right? Wrong. The markets are now in an incredible situation where bad news is good news. Meaning, the more bad news the longer the central banks will continue to accommodate, which is bullish for asset prices. The question is when this mechanism will end.

Until then, investors seem to load up on all asset classes, with negative Eonias, Italy trading through Treasuries and London and New York property prices on a one-way street.

Not missing the opportunity

After over a decade of stagnation and recession, Italy finally has an opportunity to change gear and turn the wheel towards a period of sustainable growth. Most of Europe and the main western economies have by now recouped the GDP loss derived from the financial crisis of 2008-09. Real estate values, the initial ‘culprits’ of the crisis, are back or above their 2007 high water mark in many western capitals. Not so Italy, where real estate prices are still hovering at the bottom, 30-40% below previous highs. Both London and New York have seen foreigners among the largest buyers of premium real estate. It is likely that Italy will follow when foreign investors will see that Rome and Milan trade at an unusual discount to other western capitals—another form of ‘spread’. One reason for this is due to the low foreign direct investment of the last 5 years. The government should work hard to reverse this issue. The news of last week that an American company decided against investing in Italy because of its fear that its patents wouldn’t be protected in Italy due to the lengthy civil litigation processes are not a good sign. Renzi has a lot to do, but he should instruct his justice minister to look very seriously into a dramatic fix to Italy’s notoriously inefficient civil justice system. If foreign investors cannot trust Italy to protect their IP, they will vote with their feet and move elsewhere.

Tax and labour laws condemn Italy to Sluggish Economy

Imagine a medium sized service company which has been making a small pre-tax profit in virtually all the last six years but that has declared a loss after tax every year, due to taxes on turnover rather than profits. Imagine an employee in this same company which has over 15 employees and is therefore not able to dismiss employees for almost any reason that has been suffering of a psychological condition that no doctor or hospital has been able to diagnose, and who has been on sick leave for about 180 days in each of the past two years. The law says that after 180 days of sick leave in a calendar year, the company can dismiss the employee. However, in practice the employer that takes advantage of this law may risk a countersuit by the employee stating that the condition was due to his working conditions and could conceivably ask for his ‘job’ back and compensation!

These facts that do take place in Italy are the main reasons why Italy is condemning itself to sub-par growth, or actually no growth at all, and inevitable un-competitiveness vis a vis its peers in Europe. There are no other reasons for Italy’s condition. Italians are in general hardworking, talented, creative, and elegant. Their cars, furniture, boats, jewellery are among the best in the world. As an industrial power, Italy is only second to Germany in Europe, and yet, its position is sliding by the day. We heard from a respected accounting firm that most of their non-routine assignments in the last twelve months have been managing liquidations of companies that have given up on Italy, and sometime simply close in Italy and re-open in Switzerland, Eastern Europe, or the Far East. Some even go to North Africa, despite the political uncertainty.

Until Italy’s politicians come to term with these basic facts, all their measures including this year’s stability bill are only going to be a drop in the ocean. Italy needs structural reforms in taxation and labour laws that will enable it to compete with its western peers, without needing to dismantle completely the welfare state, but by addressing the poor allocation of priorities and resources, chiefly imposed by the labour unions whose mandate is to keep the (poorly paid) jobs that are in place and not create new, better paying jobs for the young and unemployed.

Italy, what a mess once again!

Let’s go back a couple of years. Europe’s problem countries used to be nicknamed the PIGS (Standing for Portugal, Ireland, Greece, and Spain). Shortly thereafter, an extra “I” was added to make it PIIGS and include Italy. It is now fair to say that all the PIGS have acknowledged their problems, negotiated a track to come back to fiscal sanity, and are more or less coming back. Even Greece, with its clampdown on the neo-Nazi party seems to be slowly but surely coming to terms with its issues not only economically, but also politically.

Unfortunately, Italy seems to be following its own route which bifurcates; economic policy is on a sound track, thanks to Monti, Letta, Saccomanni, Draghi, while politics is still in the ice age. It is very disappointing that neither Monti nor Letta have been able to propose to parliament a draft new election law in the last two years, and it is no wonder that the initiative is now with the 5-Star movement who says it has published its own draft, but is clearly quite happy with the current version. Except that it is quite likely that towards the end of the year the Supreme Court will rule that law, the famed porcellum, unconstitutional. Add to this that Berlusconi would like elections this year, and that his party appears to be fracturing, and you understand why Italy is in chaos.

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.

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.

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.