While Rome Burns
In a normally historic strong earnings week that saw the EU reject Italy’s budget and both AMZN and GOOGL disappoint markets remain under pressure in a normally strong US earnings season. Why? Three reasons:
1. The overhang of the US rate hike and the resulting upward pressure on the Dollar,
2. The liquidation of premature and possibly overly optimistic longs into still strong (even if occasionally disappointing) corporate releases.
3. A weak Euro and European stock market due to the continued concerns over Italy and in particular the fallout from the proposed Italian budget.
Over the last few weeks we have focused on both the earnings season and the impact of bond markets and in particular US yields on the USD and stock markets. We have continuously deferred covering Italy until it was uppermost in people’s minds but more importantly, the opportunity was right. Italian and indeed many European crises have a habit of being prolonged and pressurising European markets often to a point where so much bad news is continually discounted that even when the resolution is not particularly favourable the market outcome is positive. This week we believe the timing is perfect, that Italy could well be the trigger for a reversal in the fortunes of Europe at least versus the US.
Political analysts would have you believe that Italy is in a permanent state of fragility lurching from one self-made crisis to the next. Market analysts would have you believe that the current crisis or development is worse than normal taking the Italian government, bond and stock markets and therefore European and global markets to breaking point.
Many are perhaps understandably drawing parallels to the previous Greek fiasco and the previous Italian Banking crisis—including chartists like ourselves.
And yet most if not all these crises are resolved in some fashion allowing markets if not governments to recover at least until the next one. The current crisis started with the March elections which saw the eurosceptic free-spending Five Star and right wing Lega win the election.
The latest problematic episode started at the beginning of October as it became clear that the government was about to publish a free-spending budget, focused on welfare, not investment, increasing the country’s deficit by three times what the previous government had agreed with Brussels—and the borrowing required to fund this is getting ever more expensive, with another new high after Moodys cut Italy’s rating on Oct 19. This, of course, was delivering on their election promises, but the proposal budget, increasing national debt beyond the current 131% of GDP breaks EU spending rules (the ceiling is supposed to be 60%), and was duly rejected by Brussels on October 23, an act unprecedented in the history of the EU. We now have a Mexican standoff between Rome and Brussels, with deputy prime minister Salvini playing the role of Nero, fiddling whilst Rome burns. If Italy fails to comply, it faces fines under the EU’s excessive deficit rules, which further fans the flames.
Indeed on Friday there was little relief when the S&P rating on Italy was left unchanged at BBB, two notches above junk, and one above Moody’s (who use different nomenclature). The agency did lower their outlook from ‘stable’ to ‘negative’, but the surprise rating hold was enough to push yields down by 4bp. S&P estimate the deficit will grow by 2.7% in 2019 (2.4% was the 2018 figure). Italy’s current annual GDP growth is 1.2%, well below the EU average of 2.1%.
The implications not just for Europe but particularly Italian debt holders (notably European banks) is clear. Indeed this partly explains why the German and Italian MIB have shown a reasonably strong correlation for the last year.
And yet the Bund has followed the normal safe haven pattern as the market divests of Italian bonds and flies into quality, ie Germany. The rotation is clear and explains why both Bund yields and the German DAX have both been relatively weak with the resulting downward pressure on the Euro.
And yet this divergence and period of political and market instability is rarely sustained.
On average, a normally heavily discounted Italian crisis runs for 20 days in the EURUSD before the market stabilises and recovers.. where we are now.
The implications for the Euro are clear. But context is always important. Particularly in a global stock market that is driven by capitulation in the US.
The current sell off in the Italian MIB is mature and with a possibly self-stabilising mechanism in Bunds, EURUSD and the now correlating DAX we believe this week could well produce a surprise in the German stock market. Although further later capitulation in the US may prevent a sustained recovery in European markets for now, this suggests this week could well be the first of several opportunities to buck an Italian trend at least.
We are often complimented on the quality of our weekly newsletter but sometimes with the qualification that it is too broad to take trades off. Fair point but that is intentional.
The weekly newsletter has three clear AIMs:
1. Actuality. To inform readers of what we believe is really moving the current market. Market sentiment is driven by perceptions, frequently misconceived, influenced by emotion and often unsupported by the facts.
2. Instruction. To ensure we routinely and thoroughly research these factors for our own analysis so our premium subscribers understand the references made on our analysis pages during the week.
3. Marketing. To show that we have the evidence to make accurate forecasts based and successful trade recommendations and signals. Our performance shows that we do.
Here’s to making the very best.