Italy is the Weak Link in Europe

The capital outflow from the emerging markets is proving as destabilizing as the previous inflows.  Pundits can talk about currency wars all they want, but the real issue is the ability to cope with volatile capital flows, which is the price of integration in global economy.  

In fact, the real surprise is the limited resort to outright protectionism, and surely nothing on the scale of Smoot-Hawley et.al.  That fact that the World Trade Organization has been busy hearing cases is  not as much a sign of insipid beggar-thy-neighbor policies as it is the functioning of a conflict-resolution mechanism to prevent a tit-for-tat escalation of a genuine trade war.  

The pressure on capital markets in the emerging markets--currencies, equities and interest rates--may be eclipsing other developments at the moment.  One of our key interpretive points has been that the European crisis may have enjoyed a respite, but come next month it will resurface and once again be a key element of the investment climate.  

There are, after all, several unresolved issues, including the Greece's funding gap, Portugal's status and whether a new program is necessary, and more developments toward a banking union.  It is debatable how much the proximity of the Germany election is stalling progress and how much is owed to the summer holidays and high level meeting schedules.  

In any event, it appears that Italy is moving into position to be the most immediate challenge in Europe. Italy chafes under the Teutonic ordo-liberalism (that Draghi has said is enshrined in the ECB).  It problems are set to resurface prior to the German election.  

Investors will receive a small taste of what is to come as early as tomorrow.  The Italian cabinet will debate the controversial property tax and VAT under a cloud of tensions spurred by Berlusconi's conviction of tax fraud and pending a vote in the Senate to enforce the court ruling that the former prime minister should be barred from public office for several years.  

The more the center-right succeeds in its push to abolish the controversial property tax on primary residence and resist the VAT increase, the greater the fight promise to be over filling the funding gap that will be evident when attention turns to the 2014 budget. 

Tactically, the Letta government has little choice.  It is better to postpone implementation of taxes that to repeal them, which was what the center-right pushes.  This a congenital defect inherited from the Monti government, whose legislative agenda relied on ruling by decrees.   Abolishing the taxes altogether now would likely not only this government, but likely future governments as well, from re-instituting such increases, leaving the Italy fiscally vulnerable.   

That said, remember, Italy has a primary budget surplus.  That means that excluding debt servicing, Italy is running a budget surplus.   Another way of saying this is that tax revenues are sufficient to cover current expenses.  Given the recessionary conditions, raising taxes for the sole purpose of reducing the debt inherited from past mistakes does seem foolhardy.  

The Letta government is terrible circumscribed by the fragile grand coalition that was ultimately foisted on the political system by the threat of a presidential resignation that could have triggered a constitutional crisis.  This means that it is too weak to address any serious problem, including the kind of electoral reform needed to prevent continued weak governments.  It has focused instead on largely small measures that are not very controversial.  Yesterday, for example, it moved to cut the funding of official autos by 20%.  It moved to reduce the number of short-term employment contracts of given to civil servants.   It also focusing on accessing EU structural funds.  

Many members of Berlusconi's center-right party have threatened to resign from government if the center-left votes to strip Berlusconi from office.  That debate is set to begin on September 9 and reports suggest it could take a few weeks before the whole chamber votes on the measure.  To be clear, not outcome is good for Italy.  

If the court decision is enforced by the Senate and Berlusconi is banned from political office, the Letta government could very well collapse.  This would put Italy in a precarious position to draft the 2014 budget.  And without electoral reform, a strong government is almost impossible to envision.  Of note, Grillo's 5-Star movement has waned a bit in the polls.  However, despite sectarian infighting and being arguable marginalized in recent months, it may still be a potent political force.   

On the other hand, if the center-left does not muster the strength and courage to enforce the ban, Berlusconi has the Letta government over the proverbial barrel.  It will confirm that the center-left does not want to go to the polls and this will allow Berlusconi to dictate the terms and drive the 2014 budget. 

It would demonstrate one of Berlusconi's supporters main claims--that the center-left cannot defeat the former prime minister at the polls--and looks for other means to do so.   It would not simply be a victory for Berlusconi, but it would represent a demoralizing defeat for the center-left and its leaders that emerged since the Clean Hands investigations.  

The re-emergence of simmering political problems in Italy will have clear implications for investors.  Italian assets, both bonds and stocks, have already begun under-performing.   The 10-year yield is up about 40 bp over the past three months, a third of which has taken place over the past week.  

The premium over Germany has widened nearly 30 bp since hitting a 2-year low earlier this month. The discount to Spain has been reduced to its smallest since March 2012, when Italy's benchmark yield fell below Spain's.  Italy's 2-year yield has pierced the 2% threshold for the first time in a couple of months.  

Rising bond yields has coincided with the under-performance of Italian equities.  Over the past five sessions, the Italian bourse is the worst performing G10 equity, losing about 2.25%.  Banks are among the worst performing sectors.  It is Italy's banks that are the real Achilles Heel, not so much government finances.  

This in turn may help explain the fact that the sovereign credit default swaps have risen in price more than one would expect given the magnitude of the rise in sovereign yields.  It appears that the CDS market is being used to hedge not only sovereign exposure but Italian banks as well.  Rising bad loan books have already contributed to a weak outlook, but banks seems ill-prepared for an increase in interest rates.  Moreover,  Italian banks have generally lagged other banks in repaying the long-term repo money borrowed from the ECB.  

 Italy's challenges on threatening to bust the seams of the fragile calm of the euro area over the past couple of months.  The combination of Fed tapering and an Italian crisis will have negative knock on effects on other peripheral markets and could be the spark that reignites the European crisis.