After an initial bump, markets took the news of the Italian referendum vote in their stride. Does that mean Italy and Europe are out of the woods?
That’s what I asked Tim Price. The answer was… probably not.
The reason why is simple. There are genuinely worrying problems within the Italian banking system that won’t just go away. Political instability threatens to expose them and perhaps even make them worse. But ultimately it comes down to debt.
Tim’s been warning of this all year, so you’ll probably be familiar with the argument now. The Italian banking system is wracked with non-performing loans: loans that are likely never going to be paid back. The number ratio of non-performing loans in Italian banks is heading towards 20%. In Britain it’s 1.4%. The global average is 4.9%. It’s a mess.
Against that backdrop there are more acute problems. The oldest bank in the world, Monte dei Paschi di Siena, needs a bailout. The non-performing loans figure suggests the entire system might. It’s much harder to negotiate a bailout (or a bail-in) when your government is leaderless.
That’s the backdrop. So what is Tim looking at now for signs the situation in Italy is deteriorating? Last night he pinpointed four things. I’ll explain them in turn afterwards:
Things to watch:
1) The spread of BTPs (Italian government bonds) over bunds (German government bonds) – any meaningful widening would denote rising credit fears.
2) CDS (credit default swap) spreads of Italian bank debt – ditto.
3) The share prices of Italian banks.
4) I would personally favour owning GBP or USD over EUR. And watch the VIX index for broader macro fears.
To take that list in order and give you some context and explanation:
The “spread” between Italian and German bond yields is significant. Remember, both countries borrow in euros and are backed by the same central bank. So if the markets demand more yield to lend to Italy, it suggests Italy is less creditworthy and therefore a greater risk. That’s the first place to look for a loss of confidence in the country. I’ll track that number over the coming weeks.
Point two is self explanatory. Credit default swaps are a way of insuring yourself against a financial/banking crisis. If the spread goes up, that means markets are demanding a higher premium – another sign of failing confidence.
The share prices of Italian banks have already been decimated this year. Many of them trade below the lows seen at the height of the 2013 eurozone crisis. It’s an easy bellwether for sentiment in the market.
Tim’s final point is important. Watch the VIX – the volatility index – for signs the problems are spreading. What began as an Italian problem could become a European wide one… perhaps even a global problem.
All this talk of Italian political instability has me thinking about Britain. For all the volatility we’ve seen – and the political infighting – what has actually changed in the UK economy?
That’s a question I asked myself while updating a special Capital & Conflict report on Brexit. I thought I’d include my updates for you directly today. Let’s dive straight in and take a look at some of the key developments in the markets since Brexit.
It’s important to note when we’re looking at the economy that Brexit hasn’t happened yet. There has been no change to trade policy or our relationship with the EU. Therefore economic data is more a representation of people’s confidence and outlook.
Of course, before the vote we were told the uncertainty alone would be enough to damage the economy. That hasn’t been the case. The first official growth figures for the economy after the vote showed GDP grew by 0.5%. That was slower than the 0.7% in the previous three months. But it still beat forecasts.
We’ll know more about the longer-term outlook for the economy as time goes on. Much of it will depend on the outcome of negotiations. But in the meantime, the expected knock to growth brought on by uncertainty hasn’t materialised.
The Bank of England responded to Britain’s “Leave” vote in a predictable way. It promised more easy money: lower rates and more money printing (QE).
This time it was received differently, though. Where David Cameron and George Osborne were happy to support Mark Carney’s loose money policies, the new government wasn’t. Perhaps Theresa May was quicker to understand the wider implications of the vote than Carney: it was a repudiation of the status quo on a monetary, fiscal and social level, as well as the political.
This became clear when May spoke at the Conservative Party conference in September. Describing the loose money policies, she said:
People with assets have got richer. People without them have suffered. People with mortgages have found their debts cheaper. People with savings have found themselves poorer. A change has got to come. And we are going to deliver it.
That put pressure on the Bank of England. Carney wasn’t happy. But he later announced that the extra interest rate cut and stimulus wasn’t needed and reversed his decision.
The pound has been on the sharp end of the Brexit saga. As a high liquid global market it’s the first place to respond to new data, political posturing and legal wrangling over how Britain should leave the EU.
The pound fell to a low of $1.18 against the dollar – suffering a flash crash on the way down – having been at $1.70 a year before. That’s a dramatic move. But it’s more complicated than simply a case of “Brexit is bad for the pound”.
Former $3bn fund manager Charlie Morris, who advises private investors in his The Fleet Street Letter newsletter, summed the move up like this:
For the move from $1.70 to $1.50 I blame overvaluation. $1.50 to $1.30, I blame the short-term uncertainties surrounding Brexit. For the fall from $1.30 to $1.20, I blame the Bank of England and its overly-easy monetary policy. When that is reversed, expect the pound to rally straight back to $1.30.
That was in early November. The pound promptly rallied. It sits at $1.26 as I write this in early December. Charlie expects it to keep rising.
The falling pound was like rocket fuel for the FTSE 100. It soared in the aftermath of the vote, as the pound sank.
These two trends are connected. The FTSE 100 is stuffed full of companies with huge overseas earnings. A falling currency is great news for these firms. If you’re in any doubt of that, just look at the following chart. It shows the pound (blue line) dropping as the FTSE 100 (red line) jumps.
That’s largely become a tired trade now, as the pound has stabilised. According to Charlie Morris, the big opportunity now is in FTSE 250 stocks, which have a much higher proportion of domestic earnings and should benefit from a move higher in the pound.
Investment in the UK
The low pound probably did some good in attracting new business to the UK – easing over fears of an uncertain future. A low pound makes Britain an attractive place to do business for foreigners.
Last autumn Apple announced it would move its UK headquarters to London’s Battersea Power Station, leasing 500,000 square feet in the formerly derelict power station. Roughly 1,400 employees will work there.
Google also got in on the act, announcing that its enormous “landscraper” UK HQ would go ahead. On top of that, Nissan also announced it’d invest in a manufacturing plant in the North East. All of those moves showed the fundamental strength of the UK economy – despite a measure of uncertainty, there are still plenty of reasons to invest in the UK.
The falling pound has also made UK property more competitive to overseas buyers – which is one of the reasons the market has shown strength since the vote.
After falling in July and August, asking prices rose in both September and October. In particular, the market outside of London has performed well. As the International Business Times put it, “the biggest pickup in house buying interest over the last month has come in the North of England, the West Midlands and Northern Ireland”.
A key change since Brexit has been a reversal in the bond market. This isn’t necessarily something triggered by the vote itself. But anti-establishment votes in Britain and the US have led to a change in outlook for the world economy. Fiscal policy (government spending) is back.
That’s led to a change in inflation expectations (something the falling pound has added to). In turn that has slammed the bond market, which lost $1.7 trillion in November. As bond prices fall, yields rise. That means both inflation and yields could be rising at the same time in the coming years. That’ll have significant effects on the market – and the economy as a whole.
We’ll be covering all of them in detail in the pages of Capital & Conflict.
Until next time,
Associate Publisher, Capital & Conflict