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 Italian election–investment significance

I’ve always found the Italian stock market–yes, there is one–to be a waste of time for foreigners.  There aren’t very many interesting companies (I’ve only held Tod’s and Bulgari in my portfolios, other than when I’ve taken on turnarounds).  Also, to my mind the market there is run for the benefit of political and industrial insiders, not for the average Italian, and certainly not for investors from other parts of the world.  Even if I could have tapped into the underground flow of inside information, it’s not clear it would be usable without violating US securities laws.

Anyway, the current election issue isn’t about the viability of Italian stocks.  It’s about the viability of the euro.

setting the stage

Italy is the third-largest economy in Euroland, after Germany and France.

Italy has a very inflexible, high-cost, slow-growing economy.  Many of its industries are under competitive attack, not only from elsewhere in Europe but from emerging Asian giants like China, as well (think:  clothing, leather goods and furniture).  Rather than allow/force adjustment to the new reality, the Italian government has borrowed lavishly and spent with abandon to help keep an uncompetitive economy above water.  For a long time, although bond investors saw the government debt piling up–it’s now around 140% of GDP, they assumed that Euroland as a whole was guaranteeing repayment.

Then the Greek crisis erupted.   …and bondholders began to work out that:

(1) maybe Euroland wasn’t really guaranteeing Rome’s borrowings, and

(2) the debt was so big that maybe Euroland couldn’t make good even if it wanted to.

Seeing the credit markets closing their doors to Italy, the country ousted the prime minister, Silvio Berlusconi, who had overseen the creation of much of the mess, and replaced him with a “technocrat,” Mario Monti.  (“Technocrat” means combination hatchet man and fall guy–someone who would make necessary, but politically suicidal, reforms and then fade into the woodwork.)

Monti did heroic work.  He wasn’t able to address sky-high labor costs, but he did restore government spending to what’s called a primary surplus, meaning that government income is covering all expenses, ex interest on debt.  The country’s government bond mountain is no longer growing; it’s starting, very slowly, to shrink.  To put this in context, this is more than Washington has had the courage to do.

the election

Monti got nudged out and an election was called to form a replacement government.  It was held last Sunday/Monday.

Four main parties:

–the Democrats; labor-backed, reform-friendly;  led by Pier Luigi Bersani

–People of Freedom; roll back reforms, start spending again; Berlusconi (a figure sort of like a cross between Nixon and Rupert Murdoch, without the redeeming qualities)

–Civic Choice; pro-reform; Mario Monti (who decided not to fade into the woodwork)

–Five Star; get rid of the political establishment, default on government debt, leave the euro; Beppe Grillo (like Jon Stewart, only taken seriously).

pre-election polls 

Polls from fifteen days ago, the latest allowed by law, predicted the Democrats would get the most votes (45%?)  and would form a coalition with Civic Choice (15%?).  Grillo might get 15%.  With 25%, Berlusconi would be left out in the cold.

“instant” exit polls

In Italy these are done by phone.  They’re not reliable.  But they showed the expected outcome.

as it stands now

Later polls, and preliminary voting results, show a different picture.

The Democrats will win the lower house outright.

In the Senate, however, it looks like this, according to USA Today:

Bersani          32%

Berlusconi          30%

Brillo          24%

Monti          14%.

In other words, the two pro-reform parties, led by Bersani and Monti, would fall short of a majority in the the upper house, so the coalition they had been planning on forming would be useless.  Why?    …both Brillo and Berlusconi did a lot better than expected.

where to from here?

No one knows for sure.

None of the others want to link up with Berlusconi.  That leaves a possible Bersani-Brillo combination.  But it’s not clear they have enough in common to form a coalition.

It may be that another election is on the cards.

investment significance

From the perspective of a global investor with no intention of buying Italian equities–Prada IPOed in Hong Kong, after all–it isn’t, strictly speaking, necessary for me to see Italy solve its structural problems.  All I need is for the country to limp along in its current state of denial, on the road to insignificance.  I might even be able to stomach a rollback of some of the Monti reforms.   That’s providing Italy doesn’t repudiate its debt, leave the euro, turn its primary surplus into a deficit or otherwise punch a big hole in the bottom of the euro boat.

At this moment, I consider the stuff on my “bad” list as highly unlikely to occur.  Nevertheless, absent a miracle solution to the Italian Senate partisan logjam, we’re going to go through a period of Euroland jitters until Italy has a new government.  My guess is that the shaking will mostly take the form of euro weakness.  Also, dedicated European equity investors will likely make their portfolios a bit more defensive, and will probably get the funds for doing so by aggressively trimming recent outperformers.

With little European exposure myself, I’m content to remain on the sidelines for now, with an eye out to possibly add shares of Europe-based multinationals that may come under selling pressure.

Note:  One minor conceptual worry–not one for today or tomorrow, though.  I’ve been channeling my inner Trotsky for a while now.  I’ve already consigned Japan and Europe to the dustbin of history–with a potential double dose of bin for Greece and Italy.  If I  keep on going like this, at some point there’s more dustbin than anything else.    That would be bad.

brain drain in 2012

what it is

“Brain drain” is a term coined in the UK after WWII to describe the outflow of human intellectual/scientific/economic talent from a country.  Motivation for the outflow can sometimes be religious or ethnic persecution in the home country.  More benignly, brain drain is more likely motivated by economic prospects that are perceived to be significantly better away from the home country.  According to Wikipedia, the term may have been initially used to describe the movement of British citizens to the US, or to the inflow into the UK of citizens of India.

where is it happening today?

What forms of brain drain can be seen in today’s world?

the Eurozone

–I think we should watch the EU carefully, especially southern Europe.  On the one hand, government finances in Italy, Greece… can’t be fixed by raising taxes.  People will move into other parts of the Eurozone, for one thing,  History also shows that higher tax rates invariably trigger increased tax evasion.  So higher rates can end up generating lower revenue.  (This isn’t just a European phenomenon:  New Jersey has just released an economic study showing the state is suffering a net loss of $150 million in annual tax revenues as a consequence of two income tax rate hikes early in the last decade).

Even though cost-cutting will be the main tool European governments will use to balance heir budgets, the economic stagnation that austerity measures will produce may cause an outflow of intellectual talent from southern Europe to France or Germany, or outside the Eurozone to the UK.

the US

–Anecdotal evidence suggests there’s a budding trend toward emigration from the US to China, because of the latter’s superior economic prospects.  There’s also a movement on the Northeast to create publicly funded schools that emphasize Asian culture and history–and where instruction might be in Mandarin.

–a combination of high taxes, lack of home-grown engineering graduates and immigration restrictions that severely limit the number of Indian and Chinese engineers able to work in the US has meant a continual outflow of technology manufacturing away from the US.

China

–To my mind, the most curious case of potential brain drain is that recently reported by the Wall Street Journal It’s the potential outflow of wealthy Chinese from the mainland.  They’re not seeking political or economic freedom, or at least not simply that.  What’s prompting them to consider emigration–overwhelmingly to either the US or Canada–are social concerns, including:

–poor schools

–bad medical treatment

–pollution

in that order.  Also:

–unsafe food (local municipal authorities sometimes offer industrial waste disposal sites for lease as agricultural land), and

–the one-child policy.

investment implications

At this point, these developments are more curiosities than anything else.  But events in southern Europe bear close watching.  That’s the place where emigration has the most potential for economic disruption, in my opinion.

the EU financial crisis won’t be over any time soon

how the EU got into this fix

1.  For many years the EU ran a money policy that was just right for a Germany struggling with the integration of the former East Germany, which had been run into the ground economically during Soviet rule.  But that stance was much too stimulative for peripheral countries like Ireland and Spain.  The extra money sloshing around there found its way into highly speculative real estate.  This ultimately resulted in lots of bad bank loans.

2.  The big commercial banks in the EU served as a dumping ground for large amounts of toxic sub-prime securities from the US.

3.  Rather than recapitalizing its banks in 2009, as the US did, the EU decided to paper over their losses and hope that economic growth would eventually restore the capital the banks had lost.  That has proved to be a big mistake.

These factors have been well-known for years, however.

What’s relatively new is concern about the EU’s “bad boys,”  Greece and Italy.

4.  It took several years of truly heroic economic reform for Italy to meet the minimum standards for approval to enter into the Eurozone.  The other members might have hoped Italy would continue to strengthen itself once it was in.  But instead, Italy used the borrowing power of the euro to avoid any further adjustment to a fast-changing world, preserving an increasingly non-competitive status quo by running up excessive government debt.

In hindsight, Greece seems to have gotten into the euro only because all parties decided to pretend it met the minimum criteria.  Once in, Greece borrowed up a storm and lied about it for close to a decade–both understating the amount of debt it was running up and overstating its economic growth.  That deceit ended only when a new party took power in Athens last year.  If that weren’t bad enough, the big EU commercial banks appear to be on the losing side of billions of euros of Greek credit default swaps.

where we are now

Greece

The EU and the IMF are trying to arrange a partial bailout of Greece.  They’re doing so in a way they think will avoid triggering the CDS payout provisions, even though Greece will only have to pay back half of the face value of the bonds it has issued.  This is not a move calculated to win friends (or trust) among those who have been betting on Greek default, implying that the amounts are large enough that the banks can’t afford to pay.

The big question is whether Greece will go along with the austerity measures the IMF is proposing in exchange for debt forgiveness.  Another new government is in place.  It’s made up of “technocrats,” which means roughly that they’re supposed to wield a cost-cutting axe and then withdraw from public life.  But will Athens actually do any of the things it has promised?  No one knows.

The EU is simultaneously preparing Plan B, which would be to expel Greece from the euro.

Italy

Greece is poor and too small to matter.  Italy, on the other hand, is wealthy and too big to fail.  Italy, too, has just installed a new government of “technocrats.”  It has also successfully gone through a severe restructuring in the past, just to get into the euro in the first place.  So history says Italy can (and will) do so again.

my thoughts

Good news on restructuring in Greece or Italy will be slow in coming, because political processes take time to work out.  Bad news, on the other hand, like that Athens refuses to do anything, tends to surface right away.  Because of this, I think the news flow from the EU for the next few months will be generally neutral to negative and will be a net drag on world stock markets.

My guess is that markets are now almost fully discounting the possibility that Greece will leave the euro and that Italian economic reform will be slow but ultimately successful.  For what it’s worth, that’s also my base case.

I’ve argued in previous posts that the EU as a whole is already small enough in world terms that its likely economic performance isn’t enough to move the global needle one way or the other.

The real worry for non-EU investors is that failure of a large EU financial institution as a result of the EU’s cumulative problems will happen–and that this will have a Lehman-like negative effect on world trade.  I think this outcome is highly unlikely.

If that’s correct, we have two potentially negative influences from the EU to deal with in the coming months:

–uncertainty about Italy, and

–bouts of panicky selling by Europeans, for whom the crisis is far more important than it is for the rest of the world.

On the other hand, I agree with Goldman that a self-sustaining economic recovery in the US  is already underway.

My conclusion?  …avoid the EU for now and watch for potential weakness elsewhere to upgrade your portfolio holdings.