Buy These Before The “Fed-Up” Crowd Destroys The EU

Italian voters resoundingly rejected constitutional reforms proposed by Italian Prime Minister Matteo Renzi on December 4, leading Mr. Renzi to announce his resignation. Roughly 60% of Italians voted “no,” higher than the polls projected and ending efforts to overhaul Italy’s profoundly dysfunctional governance structure. Italy’s economy hasn’t grown in a decade. Voters decided to follow a path that will likely bring the populist 5 Star Movement, which campaigned against Mr. Renzi and his agenda, into power with a platform that includes a non-binding referendum on Italy’s EU membership, an end to EU-mandated government spending limits, and income guarantees for all citizens (of course, like all populist and progressive movements, it doesn’t offer a realistic pro-growth agenda). Polls suggest that 5 Star has roughly the same level of support as Mr. Renzi’s Democratic Party if parliamentary elections were held today.

Coming a few months after Brexit and less than a month after Donald Trump’s election, the Italian vote is the latest indication that voters’ patience with the status quo has run out.

The worm has turned. We’re seeing a massive backlash against the establishment.

So far, that hasn’t translated into market instability – in fact, equity markets rallied after the vote, something that many people, myself included, did not expect.  But long-term, we’re looking at a very different story.

Here’s what’s going to happen – and how to profit.

A Complex Tug of War with European Banks At The Middle

While Austrian voters rejected a far right presidential candidate on December 4, upcoming elections in France and Germany may further an anti-establishment agenda that opposes open borders and the overbearing and intrusive management of the European Union. French presidential candidate Francois Fillon is promoting an economic program that challenges the socialism of failed president Francois Hollande (one of the least impressive men ever to hold high office in the world). German Chancellor Angela Merkel faces a tough election in which she will be forced to defend immigration policies that changed the nature of German society.

These challenges to political orthodoxy (socialism is considered normal in France, which explains France’s pathetic economic record) come as the flaws of the European Union and the failures of the European Central Bank’s quantitative easing and zero/negative interest rate policies grow more apparent by the day.  Today, the European Central Bank announced that it is extending QE through the end of 2017 but reducing its monthly purchases to €60 billion, an amount that is becoming increasingly difficult to achieve in Europe’s illiquid bond markets.  European bond markets sold off on the news with yields rising over 10 basis points in early trading.

While Italian voters appear headed down a dead end in supporting a party like 5 Star, French voters have a much more constructive alternative in Mr. Fillon, who understands that free markets are the only way forward to a better economic future.

As noted above, markets shrugged off the rejection of the Italian referendum, rallying after the news. This is the third time that markets rallied after rejection of the status quo – the first being the post-Brexit rally and the second the post-Trump rally. I did not expect markets to react positively to the Italy vote, which I was confident would be a “no,” because any movement toward breaking up the European Union, however necessary in the long run, is highly destabilizing to markets.  While I am sympathetic with 5 Star’s desire to exit the European Union, ideas like guaranteed income are the type of utopian nonsense that leads nowhere.

The title of my December issue of “The Credit Strategist” is “Nobody Knows Nothing.” That seems to me to sum up markets’ behavior right now.  To a large extent, it describes how I felt watching stocks rally in the US after the vote.  But I am confident that investors will eventually come to their senses as interest rates rise and keeps the dollar strong, pressuring US corporate earnings.

Fears of an imminent collapse of the European Union following the Italian referendum are likely overblown…at least in terms of timing. However, long term, the European Union is unsustainable and unlikely to retain its current form.

Economic union without political union is impossible to maintain. The immediate threat facing Europe is the insolvency of the Italian and Portuguese banking systems which need to be recapitalized through debt-for-equity exchanges, but there is little hope for banking systems to revive as long as interest rates are held at zero by the ECB.  The pending restructuring of Italy’s oldest bank Monte Paschi, involves a large investment from the Qatar Investment Authority and is the type of public/private partnership that is likely to serve as a model for future bank restructurings in Europe.  European banks still have hundreds of billions of dollars of bad loans to work off and are going to require a huge amount of outside capital and write-offs to return to health. A universal solution that coordinates action between governments, the ECB and deep-pocketed private investors like sovereign wealth funds in order to promote economic growth for the region. Europe remains a source of global instability that current political and economic arrangements are insufficient to address.

Instability will remain the name of the game for a long time.

For that reason, I recommend you buy long-dated puts on the European banking ETF, iShares MSCI Europe Financials (EUFN).



8 Responses to “Buy These Before The “Fed-Up” Crowd Destroys The EU”

  1. Sound of the Suburbs

    Milton Freidman thought all free and subsidised services should be removed and paid for in the private sector.

    He didn’t think how these costs would have to be covered by wages.

    He didn’t think how these costs would need to be the same in West and East in a free trade world.

    The minimum wage is set by the cost of living and must be the same in West and East for free trade.

    No one else thought either and a rent seeking real estate sector, healthcare sector and education sector have been busy in the US not thinking, raising the cost of living and pricing US labour out of international labour markets.

    Until the populist revolt occurred this was all hidden by national businesses using cheap overseas labour for manufacturing and services, where possible, while the rentiers priced domestic labour out of international markets.

    The forgotten domestic worker is now shining a light on the conflict of interests between business sectors that was obvious in the days of the Classical Economists and lead them to distinguish between “earned” income and “unearned” income.

    The Classical Economists did think about these things and thought the cost of living must be kept low with free or subsidised housing, education and healthcare funded through taxes on “unearned” income.

    “Earned” income shouldn’t be taxed as this raises the cost of doing business, real productive business that earns real wealth.

    Imaginary wealth can be produced by inflating the value of a nations housing stock until the bubble bursts and all the imaginary wealth disappears (e.g. US 2008, Japan 1989, Ireland, Spain, etc …..).

    Ditto all other financial assets.

    Anyway, the West has made a complete hash of it and free trade won’t work.

  2. I Recently moved to Portugal, purchased a house there, I took note of your fears with Portuguese Banks. A number of banks have failed here over the past few years, I have moved most of the cash funds I had here in Portugal back to the UK. To keep government compensation guarantees I have had to spread my accounts over numerous Banks. I have purchased more than 20% of my assets in gold bullion,Would it be wise for me to purchase a further 20%, my wife and I Live comfortly on the Annuity I purchased in 2008. My fear is the safety of my bank deposits, even with Government guarantees. Of course gold looks like it’s being manipulated recently.
    Many thanks Alex…………..(Over the years I had subscribed to many financial blogs, but since reading your valuable information I have reduced the total
    To Two. your advice or wisdom is most comforting)

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