The week just ended had a lot of drama. First Italy defied the European Commission on its debt level, setting the stage for another Euro-crisis, and then UK PM May revealed the long-awaited Brexit agreement with the EU – only to have two cabinet ministers resign, including if I’m not mistaken the one who negotiated the agreement! Meanwhile in the US, the president spreads baseless accusations of voter fraud as some elections haven’t been settled even a week after the vote took place.
Italy: a crisis in the making
Italy refused to capitulate on its budget plans and reaffirmed its excessive 2.4% budget target for next year based on an unrealistic 1.5% growth forecast (the market is looking for 1.0%). The European Commission may fine Italy as a result, which of course would only exacerbate the country’s budget problem. CDs rates are not back to their recent peak, but they’re still well above the average for the last few years, which suggests that the market sees increased risk of Italy defaulting or perhaps leaving the euro.
I think this risk should be negative for EUR in coming days. That’s because another Eurozone sovereign debt crisis is inevitable at some point unless the two sides work out some compromise.
Italy’s cost of financing has been rising as investors worry (not entirely without reason) about the country’s ability to sustain itself in the Eurozone.
The problem is Italy’s slow growth. Portugal has recovered back to its pre-crash level of output and Spain has surpassed it, but Italy remains mired in extremely slow growth.
Slow growth means that higher interest rates are a killer for the country. The following formula, which defines the necessary condition for the solvency of a country, explains why:
S ≥ (r-g)*D
S = the primary budget surplus or deficit (the country's budget deficit or surplus before interest payments)
r = the nominal interest rate on the government debt
g = the nominal growth rate of the economy
D = the government's debt/gross domestic product (GDP) ratio
The right-hand side of the equation takes the starting point, the country's debt/GDP ratio, and multiplies it by the difference between the country's interest payments and its growth rate. That gives us the incremental increase in its debt every year. If the country's interest rate is higher than its growth rate, then r-g will be positive and the debt burden will grow as a percent of GDP. If on the other hand the country’s growth rate is higher than what it pays for its debt, then r-g will be negative and the total debt will gradually fall.
The left-hand side is the primary budget surplus or deficit (as a percent of GDP) that the government has to run in order to prevent the debt from growing. As you can see, if r-g is positive, then the primary budget surplus has to be higher every year, otherwise, the country's debt burden will grow and grow in a "snowball" effect.
Growth in Portugal and Spain has accelerated and bond yields have come down to the point where (r-g) is negative, meaning their debt burden is falling. Italy was there for a while, but is now back above the line, thanks to higher yields. That means its debt burden is snowballing. (I’ve used the 7-year bond yield as that’s the average weighted maturity of Italy’s debt.)
There are only three ways a country can dig itself out of this hole: A) have very low interest rates, B) grow very rapidly, or C) run a large primary budget surplus. “A” is obviously out of the question at this point. Italy is hoping that a temporary fiscal boost will enable it to jump to “B”. The EC wants “C”, coupled with structural reforms to boost growth. The problem with “B” is that Italy hasn’t managed to grow rapidly for several decades, so it’s unrealistic to think that suddenly the economy will change. At the same time, the problem with “C” is that there are relatively few examples of austerity coupled with reform actually being successful in kick-starting an economy.
Italy is not a profligate borrower. In fact, it has managed to run a primary budget surplus almost every year since it entered the Eurozone, a feat that only Germany among the other Eurozone countries has managed. However, as the above formula shows, it would have to run an ever-bigger primary budget surplus every year just in order to stabilize its debt/GDP ratio. That’s not likely. Given that the Italian populace is already revolting against the establishment, it’s hard to see how a government could impose ever more austerity every year and remain in power for long.
For now, Italians are still pro-EU. As recently as September, 71% said they were in favor of “A European economic and monetary union with one single currency, the euro.” However, note that this was the lowest level of support of any major EU country (in fact, the lowest of any Eurozone country except Lithuania). But having seen the “oxi” vote in Greece in 2015, it’s easy to imagine this support eroding as the government runs up against Eurozone rules – particularly since the EC gave both Germany and France a pass when they exceeded their deficit targets.
I think the specter of a deepening crisis in the Eurozone’s third-largest economy will weigh increasingly on the euro. Greece was bad enough, but Italy has the potential to be an existential crisis for the euro.
Britain: a crisis deepening
It looked for a moment like blue skies for Britain. PM May announced a breakthrough agreement with the EU over the terms for Brexit. Finally! All that had to happen was the agreement had to pass Parliament, and the months of uncertainty would be over.
Alas, it’s not going to be that easy. UK Brexit Secretary Dominc Raab resigned in protest -- I was under the impression that he was the one responsible for negotiating the deal – as did one other Cabinet minister, plus two junior ministers. There are also rumblings of a “no confidence” vote, but so far none has materialized. In any event, it looks like the May’s long-awaited plan will have a hard time getting approval from Parliament when they vote in early December. The government only has a majority of around six and Labour has pledged to vote against the proposal, so it won’t take many Conservative rebels to scupper the deal.
Speaking in Parliament, PM May Thursday summed up the options as follows: “We can choose to leave with no deal, we can risk no Brexit at all, or we can choose to unite and support the best deal that can be negotiated,” which I presume is the one that she’s offering. Personally, I think “no Brexit at all” would be the best choice, but let’s focus on the other two possibilities. If this agreement gets voted down in Parliament, which looks entirely possible, then Option A – “to leave with no deal” – becomes the most likely outcome. That would be disastrous for sterling.
There is also the possibility that PM May gets ousted. Some pro-Brexit Conservative Party members are already submitting their letters of no-confidence. Or if she loses the vote in Parliament, she could decide to resign. In that case, what would happen? There could just be a shuffle in the Conservative Party and another, probably more hard-core Brexit member, takes over as PM. Or there could be a general election and the non-negligible possibility that the appalling Labour leader, Jeremy Corbyn, gets into office. Brexit + Corbyn = the pound finally reaches parity with USD, a possibility I last wrote about in 1984.
Moreover, there’s still the question of whether a new PM of either party could negotiate a better deal with the EU. I think not, in which case, you have two major possibilities: Corbyn + soft Brexit, or Some Conservative Party Leader + crashing out with no agreement. Either would spell doom for the pound.
The research department at Morgan Stanley put together the following flowchart on what might happen after Parliament votes on the deal. As you can see, there are a wide variety of possible endings, ranging from implementing the current proposal (“Chequers-style Brexit”) to scrapping the whole idea of Brexit and deciding to remain in the EU after all.
In short, after all this time, the uncertainty around Brexit has only increased. I think the pound is in for a rough time over the next month or so, and perhaps longer.
With both the euro and the pound suffering from fundamental crises, it’s likely that the safe-haven currencies – particularly CHF – will gain in coming months, as will the dollar.
The coming week: a volatile Thanksgiving
The week of 19 November features the Thanksgiving holiday in the US (Thursday) and the Labor Thanksgiving holiday in Japan (Friday). Many US market participants leave their offices early on Wednesday and then take Friday off as well, meaning it’s a short week in the US. The thin market in the US means that volatility is usually higher than normal for this time of year, as the following graph makes clear. The unusual crises in Europe make it likely that this year will be no exception.
The volatility is likely to be highest on Friday, when the main indicators of the week come out: the preliminary PMIs for the major economies. Germany and the EU as a whole are expected to see their manufacturing PMIs decline, while the US version is expected to rise. While the euro has been benefiting from the recent “risk on” sentiment, worries about the various crises in Europe, plus signs that the Eurozone economy is slowing while the US economy remains resilient, could put downward pressure on EUR/USD.
The other major US indicator out is the durable goods orders on Wednesday. That’s expected to show a sharp decline at the headline level, but only because of airplane orders – taking out transportation equipment, the figure is expected to rise at the fastest pace since April. That should reinforce the idea of a healthy US economy and support the dollar.
US housing starts and building permits will come out on Tuesday and existing home sales on Wednesday. The weekly Commitment of Traders report will be delayed until Monday because of the Thanksgiving holiday.
The only other major indicator out during the week is Japan’s national consumer price index (CPI) on Thursday. The headline inflation number is expected to accelerate, as the Tokyo headline CPI did. However, the two core inflation measures - Japanese-style core CPI, which excludes fresh foods, and the more standard one, which excludes fresh foods and energy, are both expected to remain unchanged. No acceleration in inflation, no chance of changing rates. JPY-negative.
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