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Sep 28, 2018

Italy bond blow-out... what does this mean... let me tell you about the real world

Italy bond blow-out... what does this mean... let me tell you about the real world

Usually we don’t go into great depth on issues like this for our readership but, in light of centrally-planned, unintelligible news sources, we wanted to provide an explanation of what actually happens in the real world.

So what is going on? Italy’s FTSEMIB index is trading down 4.5% as I type. By the way, this isn’t new, the Italian benchmark index is actually down 16% since May. Translation: that is not good.

Figure one

What is the underlying reason? Well, growth is coming in worse than expected. More than that, you could have been ahead of this if you actually paid attention to the data over the last few months. Italy PMIs (measures of economic activity) actually peaked in February.

Figure 2

When you couple this with the fact that the government is more Italy-centric (and less European-centric) than the prior technocratic (read: puppet) governments headed by Matteo Renzi (and Gentiloni, his successor). Renzi actually resigned after his proposed constitutional referendum reducing the power of the Senate failed to pass. Some commentators have argued that said referendum would have made the prime minister too powerful and would be an affront on the democracy. Renzi’s successor Paolo Gentiloni was voted out earlier this year in favor of Giuseppe Conte, who assumed office in June as the leader of the first populist government in western Europe.

Conte is much less likely to play ball with the European governing bodies in Brussels.

This is all coming to a head this morning. The deficit targets proposed by Brussels are not being adhered to and Italy today announced that it would target a budget deficit of 2.4% of GDP for each of the next three years. This doesn’t hit the improvement that Europeans would want to see.

Figure 3

As a result, Italian bond yields are getting blown out this morning…

Figure 4

And major banks like Intesa Sanpaolo and UniCredit were halted limit-down.

Why does stuff like this keep happening? (Opinion section, for the regulators)

This borders on conjecture but I have a few reasons.

First, the demographics in Europe are downright awful. People say we have it bad in the US but the population is still growing robustly, thanks to both immigration and birth rates. In Europe, immigration rates tend to be lower and the birth rate is lower as well. This limits the pool of potential labor.

And, by the way, labor is more than just the size of the working population. It is also the amount this population works. I talked to a couple Germans a few weeks ago who worked for a large company. Not only do they get 57 days of paid time off every year, but they actually get paid more for the time they do not spend working than when they do work. So if your annualized salary is, say 50,000 euros, you could earn an annualized 55,000 euros for the days you take off (don’t quote me on the actual numbers but it is directionally correct).

Second, the Brits (and Margaret Thatcher) have this one right. You can’t have a fiscal union without also having a monetary union. While the Germans are giving 2 months of paid leave per year for workers, Italy is dying because they can’t devalue their currency. Germans are able to pay in cheap euros because the currency is diluted by the profligacy of the less successful countries. This means that Germany is at a structural disadvantage to countries which allow their currencies to float and Italy is stuck with a somewhat stronger currency for its companies (and government because government employs 17.3% of the work force). This stronger currency means it is more difficult to pay workers and export goods.

Ultimately, my base case opinion is that this will result in another can-kick but it may get worse before it gets better.

As that happens we will continue to tell you about the real world because, as Yogi Berra said, “In theory, there is no difference between theory and practice. In practice there is.”

*Sources: The Bloomberg, Reuters

Benjamin Nye, CFA, FRM

Chief Investment Officer, Portfolio Manager

Ben arrived at Narwhal from a small investment firm in Eugene, Oregon, where he cut his teeth investing in individual stocks, bonds and derivatives. He earned the right to use the CFA designation in 2016, holds his Series 65 license and is a certified Financial Risk Manager. Ben received a bachelor’s degree in finance from the University of Washington and a MBA from Emory University's Goizueta Business School. In his free time, he plays competitive tennis, mentors for Mentoring for Leadership and is a frequent contributor to The Investing Podcast.

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