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).