Blotter: The calm before the European storm
On Friday, regular Expert Series guest, Jacob Kirkegaard of the Peterson Institute lit a fire under my thesis that Italian political volatility would drop post the formation of a new government, even if that government was a hotchpotch of populists of Northerners and former comedians. Take a listen to the interview and unfortunately, our conversation about fiscal deficits of 6% of GDP, rating agency downgrades, the inevitability of this government falling, new elections and the eventual emergence of a dominant far right coalition will prove to be a toxic mix for Italy. And you all thought that Italy missing the World Cup was the true Italian misery for 2018.
So, I am in the process of re-writing last week’s flagship, a report where I told everyone to calm down and focus on the data; data that continues to be strong in the US and benign everywhere else. For the next few weeks at least, this should continue to be the case and implies that the path of risk assets is higher. US payrolls continue to show strength and this momentum should support stocks and credit. There is little on the agenda from a data perspective that can derail the thinking that the global economy, especially the United States, doesn’t remain in pretty good shape. Safe haven yields should rise, EM should do fine and the Euro’s short squeeze should continue. US 10’s could trade back towards 3% and the yen should weaken.
All ok then? Not exactly. Underneath the surface are the dire medium-term concerns that Jacob outlined about Italy, concerns that may take several months to play out. At the center of this is legislation to pass three agenda items that could upend the Italian economy and plunge Europe back into crisis. If the new coalition government passes a) a universal basic income, b) the winding back of pension reforms and c) massive tax cuts via a two-tier tax code, then Italy’s widening deficit would put Rome on a collision course with Brussels, with the ECB, and with the ratings agencies. This isn’t a problem for today, but it will be later in the summer.
With market and political volatility “normalizing” post depressed levels in 2017, investors need to adjust their trading strategies and do what most folks find inherently challenging and that is to sell strength and buy weakness. Frankly, it has worked all year, yet many speculative types continue to long for the days of momentum, days that ended in February as short-term volatility strategies imploded. Despite, the likely continuation of some nasty headlines concerning trade, Turkey, and increasingly Mexico, as the election of the Leftist Andres Manuel Lopez Obrador (AMLO) looks certain, global assets should focus on current data strength. However, use this opportunity over the next month to take risk way down.
Italian concerns may dissipate temporarily but the reality of the populist agenda will become real very soon. I am not talking about Italy leaving the Euro, but I am talking about a standoff with Brussels, the demise of this coalition government, new elections and the rise of the economic nationalist Northern League. This is all by the end of the year. Under this scenario, there is no natural buyer of Italian assets, and while the fall of the Rahoy government in Spain shows the health of Spanish democracy, Italian contagion appears unavoidable. I suspect, that a strong June for risk assets could mark the high point for the year for both yields and equities.
The RBA and RBI meet this week with no change expected. On Monday Indonesia PMI and CPI, and US Durable Goods and Factory Orders. Australia GDP on Wednesday. Thursday EU GDP and German Factory Orders. On Friday, Japanese GDP and trade, German IP. China CPI and PPI on Saturday. On Page 3, Cindy will discuss Apple and Broadcom.