a new government in Italy

Italy has long been the weakest link among the three major continental European economies in the euro.  Its economy has deep structural flaws.  Pre-euro it had long been papering them over through heavy government borrowing.  That allowed it to live beyond its means, protecting industries of the past and giving short shrift to future possibilities.  Periodic devaluations of the lira let it continue this strategy by paying lenders back in debased coin.

Despite this checkered history, Italy became a founding member of the euro in 1999.  It got in by the skin of its teeth–and that only after enacting a violence-wracked series of important reforms just in advance of the deadline.  The hope back then was that once in the common currency Italy would continue down the reform path. Instead, however, it has used the privilege of issuing euro-denominated debt to resume a less aggressive version of its bad old ways.  The result has been a domestic economy laden with debt, that has shown almost no real economic growth over the past decade.

 

The leaders of a nativist political coalition formed after recent elections have been speaking about their economic plans.  Their idea is apparently to “solve” Italy’s problems by repudiating a portion of the national debt and withdrawing from the euro, presumably in order to substantially devalue a new currency.

…sounds a little like Greece, only ten times the size.

This development is, I think, the main reason the euro has been falling against the US$ since early April.

 

my thoughts

–although the new government hasn’t announced official policy, I think that what it ultimately says will be at best a watered-down version of what leaders have already been saying unofficially to their supporters.  If so, we’re in early days of a looming crisis

–to the degree that professional investors hold Italian stocks, I think their reaction will be to seek safety elsewhere

–it wouldn’t be surprising to see official policy end up being something resembling Abenomics in Japan in its broad outlines.  This implies the folliwing end result:  a substantial loss of national wealth, a higher cost of living for ordinary citizens and protection of traditional industry/established elites from negative effects.  There’s no reason to think Italy would end up any different

–it’s probably also worth noting that “protect sunset industries/stunt the future/lower living standards” summarizes the Trump economic playbook for the US, to the extent there is one.  This means we can already see in Japan/Italy the trailer of a future disaster movie for the US

–What to do in the stock market?  I think Italy has restored the safe haven character of the dollar for the moment.  Given the distinct policy negatives in the US, EU and Japan, China is looking a lot better.  Secular growth (i.e., IT) anywhere is probably safer than economic sensitivity

 

the French election?

French elections

As I mentioned yesterday, there’s at least some chance that control of the French government will fall in the Spring to a party that vows to:

–leave the euro,

–engineer a depreciation of the newly-resurrected French franc and

–repudiate euro-denominated French national debt.

This is not just like Brexit, since Brexit didn’t involve government refusal to repay previously incurred financial obligations.  It’s way worse.  This is more like Argentina or Cuba.

Sounds crazy, but so did Brexit and so did Trump.

What to do?

…particularly since it’s hard for me to figure the chances of any of this happening, and I no longer know that much about French stocks.

Two lines of thought:

–avoiding being hurt, and

–trying to make money.

Both will be brief, since I don’t know enough to say any more.

avoiding being hurt

Currency depreciation would have effects much like what’s happened in Japan during the Abe administration.  National wealth and the standard of living of ordinary citizens could take a substantial beating.  Export-oriented industries would thrive.

It’s likely that French companies would have a more difficult time raising money in global capital markets, if France refuses to honor its existing euro-denominated debt.  Companys’ repayment of debt not denominated in francs would become more costly.

Knock-on effects:  my guess is that Italy wouldn’t be far behind France in leaving the euro.  The currency union would likely end up being Germany plus bells and whistles.

The way bond investors are now taking defensive measures is by selling their French government-issued euro bonds for German issues, giving up 0.4% in annual yield to avoid a potential currency loss.

We, as equity investors, can do something similar now, by avoiding non-French multinationals with large exposure to the French economy.  If we want to/need to have some French exposure, it should be in companies that will benefit from possible devaluation–that is, firms with costs in France but revenues elsewhere.  Here the performance of Japanese stocks should be a good guide, except that I’d avoid French companies with a lot of foreign debt.

trying to make money

I consider betting on future political developments to be a dubious enterprise.  If Marine Le Pen makes an unusually good showing in the first round (of two) in French voting in April, and if the French market sells off sharply on that result, I’d be tempted to look for beaten down French multinationals, on the thought that Le Pen would lose in the second round.  I’m not sure I’d actually do anything, but I’d be willing to think about it.  This would imply beginning to study potential purchase candidates, or a suitable ETF, now.

 

 

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

internal/external adjustment and the EU

Yesterday I wrote about the tools a country has available if it faces a combination of sluggish GDP growth, excessive borrowing/weak banks and non-competitive industry (processes are outmoded and costs are too high).  Greece is the poster child among EU countries   …but Italy is the major EU economy that this description calls to mind.  France is riding a compartment or two away.

What can an EU country whose economy is structurally out of balance do?

Well, external adjustment–meaning currency depreciation–is out, since it’s part of the euro.

That leaves internal adjustment, which can take three forms:

–tariff or other regulatory barriers.  Yes, the EU can, and does, erect barriers to protect local industries against imports.  But most EU countries trade more with each other than the outside world.  So, say, Italy can’t bar imports from super-competitive Germany or lower-cost eastern Europe.

–slowing the borrowing, which is intended to maintain the current (unsustainable) lifestyle, by raising interest rates in a way that will cause a recession.  This is the German “austerity” solution, which few, if any, other countries (nor any politicians concerned about being reelected) will willingly adopt.  The EU experience after the 2008-09 recession shows austerity doesn’t work particularly well, either.

–that leaves structural reform.

This gets me to why I started writing about this.  Paul Krugman recently reviewed a book I haven’t read, The End of Alchemy, by  the former head of the Bank of England, Mervyn King. In the review, found in the New York Review of Books, Krugman says of King:

“He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.”

What grabbed me is the “imbalances in production costs” part.   In other words, despite almost two decades of having the euro, plus all the time before its debut when companies knew it was coming, inefficient EU countries have done very little to bring their production costs down.  In addition, the reason Mr. King gives for this is “the lack of will.”  In other words, the forces of the status quo, aimed at preserving local fiefdoms (both political and industrial), are so strong that no progress can–or will–be made.

Sounds a lot like Japan, with a twenty-year lag.

Tomorrow:  investment consequences, if the King/Krugman analysis is correct.

 

 

what just happened to the Swiss franc (CHF)

background

Pre-financial crisis one euro bought close to 1.7 chf.

As progressive waves of bad news about the EU financial system broke–that, for example, its banks were stuffed to the gills with worthless US mortgage derivatives, or that Greece had faked its national financial statements for years and was unable to pay its (euro-denominated) national debt–EU investors began to sell their currency and buy the chf, whose value began to rise.

In mid-2011 a sudden spike upward in demand brought the Swiss currency to the point that a euro bought less than a single chf.

the cap

That forced the Swiss National Bank to step in to stabilize its currency, fearing that continuing gains in the chf would have terrible negative effects on tourism and on exporters.  The SNB set a cap on the value of the chf at 1.2 per euro.  The chf could trade cheaper than 1.2 per euro, but the central bank would always be there to buy euros at the 1.2 rate if needed to prevent the chf from appreciating further.

problems

This action fixed the immediate problem of appreciation of the dhf against a key trading partner.  But it did two bad things at the same time:

–it effectively tied the currency to a now-nosediving euro, and

–it expanded the Swiss money supply in a potentially unhealthy way.

today

This morning the SCB made the surprise announcement that it was going to let the chf float against the euro again, effective immediately.  The currency spiked to 1.0 euro before settling in at around 1.1 euro.

Why the surprise?  

I can think of several reasons:  the Swiss government didn’t want to buy any more euros.  I imagine it anticipated it would be swamped with buy orders for the chf during any phase-out period.  Currency traders may have anticipated this move and been buying boatloads of euros from the Swiss government in recent days, effectively forcing the SCB action.

Why do this at all? 

That’s the interesting part.

Switzerland apparently anticipates that when the ECB embarks on quantitative easing, the result will be some pretty ugly currency action for the euro.

 

the shrinking euro (and yen)

the shrinking euro

This time a year ago, it cost $1.36 to buy a euro.  It was $1.39 by March.   The euro then moved sideways vs. the greenback until early summer–when it began an almost continual descent that has the EU currency now trading at just above $1.19.  That figure is down 14% from the 2014 high, and off 12.5% from the year-ago level.

reasons?  

The surprising revelation last summer that the overall EU economy was slowing, not accelerating as most observers, myself included, had expected is the most important, I think.  Sanctions against Russia and recent worries that a new Greek government might repudiate its sovereign debt have just added to the funk.

The Japanese yen has tracked more or less the same course vs. the dollar as the euro–meaning that neither Japan nor the EU has gained/lost competitiveness vs. its main global manufacturing rival.

Looking at the situation from a more conceptual level, both Japan and the EU have relatively old populations and both give much higher priority to preserving their traditional social order than to achieving economic progress.  Neither characteristic argues for long-term economic/currency strength.

consequences

economic

In the short run, currency declines stimulate overall economic activity.  They also rearrange growth to favor exporters, import-competing industries and service industries like tourism.  This means that local currency profits for firms that have their costs in euros and revenues in harder currencies will likely be higher than generally anticipated.

The huge fall in oil prices will still be stimulative, but the edge will be taken off the benefit a bit by the currency decline.

Euro-oriented holders of dollar-denominated assets benefit; dollar-oriented holders of euro assets are hurt.

financial markets

I expect European bond managers will continue to boost their holdings of US Treasuries, figuring they’ll get both yield pickup and an anticipated currency gain.  This flow will keep long-term interest rates in the US a bit lower than they would be otherwise.

Equity managers will shift European holdings more toward multinational firms with dollar-denominated assets and earnings.  Some of this has happened already.  Many times, though, PMs will wait until they see the weak currency stabilize before reallocating.  Personally, I don’t think waiting makes any sense, but that’s what people seem to do.

US firms with European assets and earnings will face the double negative of slow growth in the EU and the diminished value of EU profits in dollars.   I think US-based manufacturers of consumer staples are particularly at risk.

hedging

While the extent of the decline of the euro may be a surprise, the fact that it’s a weak currency shouldn’t be.  This means many US companies that have euro exposure will have hedged away part of this risk.

I have conflicting thoughts on this issue.  Almost universally, investors ignore profits gained by hedging.  The idea, which I agree with, is that in short order the favorable hedges will run out, exposing the weaker unerlying profit stream.  There’s no sense in paying for profits that will be gone in a quarter or two.  On the other hand, while firms always reveal hedges that have gone wrong (and argue that investors should ignore these losses), they don’t always highlight hedging that has worked.  I guess I’m saying that I’d be leery of companies with EU exposure even if reported profits don’t show any unfavorable impact.

 

 

 

the EU and negative nominal interest rates

Over the past year or two, the European Central Bank has periodically talked about the possibility of engineering negative nominal interest rates in the EU.  What it is talking about?

There are two possibilities:

1.  In overly simple terms, money policy is stimulative if the real (that is, after subtracting inflation) interest rate is less than zero.  For example, if inflation is 3% and the nominal interest rate is 1%, the real interest rate is -2%.  So cash is a loser, giving a sharp economic incentive to individuals and corporations a sharp incentive to borrow money and to invest their cash balances in projects that will cause economic growth.

Suppose there’s no inflation, though, or that prices are falling by, say, 2% per year.  If the best that money policy can do is bring nominal interest rates down to zero, the real interest rate is still +2% from holding cash.  So cash is a big winner.

In this deflationary scenario, the only way to achieve a positive real interest rate is to get nominal interest rates down to, say, -4%.  How to do so?  …tax bank deposits.

That’s not enough, though.   …and here’s where things get a little wacky.

If I’m going to lose 4% a year by keeping my cash in the bank, I’m going to buy a safe, withdraw my money and keep bills and coins in my house.  Scrooge McDuck writ small!!

Government can’t accept this.  So it puts “use by” dates on currency, so money expires at the rate of 4% a year if it isn’t spent (I said this wad going to be wacky).

But wait…  Citizens won’t accept this move, either.  They run to currency dealers (or gold merchants) and convert their money into non-imploding stuff.

Government responds by imposing controls on purchases of metals, foreign currency and maybe other commodities, too.

…and so on.

Anyway, this recipe for political and economic chaos can’t be what the ECB is talking about.

2.  As evidence has been mounting that the EU economy has passed its cyclical bottom and has begun to perk up a bit, the euro has been strengthening.  From early July until late last month, for instance, the currency had risen by about 8% against the US$.  A bit of that is fallout from the government shutdown in the US, but most is because investors are beginning to reallocate funds away from other parts of the world and toward the EU, where they sense surprising positive economic momentun.  Trade is starting to increase, as well.  Both developments increase demand for the €.

Once an uptrend like this starts, it also attracts speculative inflows of cash from large banks, hedge funds–sometimes gigantic inflows–who want to bet that the uptrend will continue.

What’s wrong with this?

It’s that a rise in a currency acts very much like a rise in interest rates–it slows down economic growth.  Not exactly what the ECB wants.

So it’s jawboning.  It’s threatening to tax large inflows of speculative cash, most likely by at least enough to offset any anticipated currency gain.  It’s hoping to fend off speculators by announcing the actions it will take to drive them away.

So far, the ECB has been successful.  It wouldn’t be entirely out of the realm of possibility, however, to see taxes placed on large bank deposits (after all, big speculators are going to deal in electronic money, not bills and coins) at some point to drive speculators away.   The main point to remember is that this won’t be some loony scheme to create overall negative nominal interest rates, just losses for currency speculators.

The main effect on investors will be to lessen the attractiveness of pure domestic EU plays and to retain some allure for EU-based multinationals.