Italy Leaving The EU Is A Legitimate Possibility

Posted: Jun 01, 2018 10:58 AM
Italy Leaving The EU Is A Legitimate Possibility

The week started off nice - a market holiday on Monday as we remembered all those who lost their lives defending America and her freedom; time with family, friends, BBQ's, etc.  Then on Tuesday, in response to the political drama of Italy (much more on this inside), the markets dropped 400 points and the serenity of the Monday holiday was gone.  But then Wednesday the market recouped the vast majority of that loss in one of the biggest rally days of the year, and investors were reminded that what zigs often zags (and sometimes within a day of each other).  So from Italy to the dollar to bitcoin to American politics, we have it all this week - join us, in the Dividend Café ...

What did we learn this week

The paragraph right below this one unpacks Italy and the market volatility of this week more, including an article I wrote for our Market Epicurean site that features all of our long-term thinking on the subject (yes, there are still people thinking long-term about these matters).  But in the shorter term of seeing the sixth or seventh flare-up of markets over the last eight years in response to some Europe-driven commotion, the following sticks out:

  • Say what you will about alleged U.S. interest rate risk, at the slightest huff or puff of global fears, the U.S. Treasury market becomes the instant safe haven of choice.  Our bond market rallied this week, big, as yields dropped in response to global capital flowing out of Italy (and elsewhere), and right here into the U.S. of A.
  • The reversal of downside volatility is becoming so predictable, that if I didn't know better, I would try to trade it (tongue is in check - it cannot be traded - I am uttering heresy to prove a point).  Those who got fearful Tuesday and played into it weren't even given the customary week or so to end up regretting their ill-timed capitulation.  By the market open Wednesday, they were left wondering why they did what they did.
  • The Euro barely budged even as we were told markets were responding to the possibility of a full crisis in Europe.  Hint: Neither the VIX, the media, or American stock markets (with all the weak hands and short-term traders therein) can ever trump currency markets as a bellwether for what is going on underneath the hood (when it comes to global risk).
  • And finally - the idea of U.S. financials being the place to sell off when Europe's financial stability is called into question strikes me as so so so 2010.  More on that later.

Italian dessert

A deeper dive on all that is and is to be in Italy, Europe, etc. can be found here.  But is the idea of Italy leaving the Euro a legitimate possibility?  It most certainly is.  Would we say it is likely in the short term?  No, it likely means "over 50% chance" - not in the short term.  But unlike many southern bloc countries victimized by Europe's monetary but not fiscal union, Italy's debt is mostly owned by Italian entities (72%, to be precise), meaning they are less reliant on international markets.  The populist forces in Italy have momentum, and any number of catalysts could force the moment.  I have my own opinions about what Italy should do, but the comment here is simply to say - there are tension points that could boil over in Brussels, leading to a certain eruption in Italy many have not planned on, impacting currency, bond yields, and much more.  It is not worth betting on, but certainly not worth ignoring.

Comparing relative strength

I have been critical for quite some time of the simplistic argument, prevalent in many circles I rotate in, that the U.S. markets have done better than Europe's for a long time, therefore Europe is now the better bargain.  As this chart, and plenty of other data points show, not all continents are created equal (in the present macroeconomic landscape).

Click here to view the chart.

The U.S. dollar's new popularity

The greenback started the year with a nearly 5% decline in less than two months and has seen a rally violent enough in the last few weeks that it is now up 2% year-to-date.  I go to great lengths to both communicate dollar/currency agnosticism and manage portfolios with dollar/currency agnosticism.  So commenting on the subject is itself outside my preferred agenda, which is to focus on those things that will matter to the long-term financial goals of my clients.  That said, in in the short term, dollar moves this quick and this severe have an impact and warrant comment.

Growth expectations for the UK, Canada, Japan, and especially Europe, have all modestly disappointed as of late.  This creates an expectation that other central banks outside the U.S. may not tighten monetary policy to the degree expected, which weighs on those currencies.  Put differently, the dollar didn't get stronger; the competitors got weaker.  This combined with the big build-up of a short position in the dollar from last year has led to the rapidity of the reversal.

It may continue for a bit.  But as the short covering winds down, fundamentally, on a trade-weighted basis, the dollar is over-valued and many other currencies (especially in the emerging markets) are under-valued.  Fundamentals always take over on their own timeline.

A fresh perspective on volatility (bitcoin)

The S&P 500 is up about 2.5% since the all-time high in Bitcoin in December.  That +2.5% comes with the extraordinary volatility of February, March, April, and May, three of which were negative months.  Bitcoin is down 59% since that point.  I may make a sticker - "Volatility: It's all perspective"

Click here to view the chart.

A differing perspective on distress in the financials

The consensus view is that the big banks and Wall Street financial institutions saw distress in their stock prices this week in correlation to the fear coming out of Europe.  Presumed balance sheet exposure to sovereign debt in Europe (Italy heavy included) is at the core of weakness in U.S. financials.  But what if that doesn't explain the whole story?  What if that explanation is not only somewhat wrong, but totally incomplete?  I would note that the Deutsche Bank Financial Services Conference took place this week as well, and several premier financial companies presented data and updates there, totally outside of the exposure to Europe.  Reliance on client credit line revenue, compressing commission revenue, continued defection of clients and personnel to the independent advisory channel - there are secular trends hurting some of the U.S. financial companies that go far beyond European bond swaps.

Is the bull market ending soon?

With gratitude to my friends at Strategas Research, the argument for what could extend this bull market (perhaps significantly, though certainly not without pauses and volatility along the way), is best expressed this way: The bull market extension theory requires business investment, and that business investment needs to increase productivity, and that productivity needs to pay for higher wages.  That is non-inflationary.  It is supply-side.  And it is, indeed, what we project.

What do the historical indicators show?

Click here to view the chart.

Politics Meets Markets: The Beltway bull & bear

  • Far and away the most significant political story of the week as it pertains to markets was the roll-back of Dodd-Frank proposed by the Federal Reserve (and other agencies).  Contrary to the fears of many on the left that a softening of Dodd-Frank regulation (especially around the so-called Volcker Rule would bring the wild west of firms recklessly trading away their own balance sheets with impunity), the changes seek to simply lower the compliance burden around the nebulous restriction on so-called "prop trading" (proprietary).  Firms no longer have to prove "intent" (that they are trading on behalf of clients vs. the firm's capital).  The testing is still rigorous for large banks, less so for medium-sized banks, and these silly restrictions on very small banks (where compliance costs hurt the most) have been eliminated.  The ban on firms using their own capital to own their own (or others) hedge funds and private equity funds were not addressed (note: it strikes us that firms owning their own hedge funds would demonstrate "skin in the game," and reduce systemic risk; now, firms are banned from doing so taking away that alignment of interest; what a strange web regulators often weave when first they practice regulating without skin in the game).
  • Thursday saw markets respond to more tariff talk.  As is generally the case, "final decisions had not been made," and "conversations were ongoing," yet a resurgence of talk that tariffs are coming, this time in a renewed threat against Mexico and Canada.  Two comments are in order: (1) The market does not respond even more negatively because it now assumes that President Trump is just negotiating and that the latest chatter will not become law; and (2) It still helps to feed a general environment of uncertainty and skittishness
  • A further political point worth mentioning: There was much talk at the time of corporate tax reform passage that if companies used the benefit to merely buy back shares and pay out dividends, it would be economically unproductive (which is untrue), and politically unhelpful (a self-fulfilling prophecy, I suppose).  While it is still early, the full gamut of potential uses of cash has been on display - from increased wages and bonuses, to share buybacks and dividends, to M&A, to CAPEX.  One use of repatriated cash many did not anticipate was the reduction of debt.  The research I am studying indicates this has been a significant use of cash since repatriation began.  It is hard to see how this would not register as a decidedly positive development for both investors and the broad economy.  High debt constricts growth; deleveraging allows for resourceful allocation of capital.
  • Are higher gasoline prices a political liability for Republicans in the mid-terms?  This will be worth continued analysis in the months ahead, but my prima facie response is that it has been a long time since we have seen gas prices move the needle much politically.

Chart of the Week

One hand giveth, the other taketh away.  Pundits and the like are bemoaning the impact of higher short-term interest rates in the economy, wondering what it will mean to stock prices, bond prices, and the overhead of borrowers who have borrowed in short-term financing mechanisms.  Fair enough.  But the corollary to the impact higher rates have on borrowers is the impact they have for savers …  Note the movement in what has been a very quick period of time on short-term treasury rates.  Holding dry powder in cash or cash equivalents has, for what seems like a lifetime, paid zero. The opportunity cost of having any money in dry powder was huge.  Earnings are now available in these short-term instruments that many thought they would never see again.

Click here to view the chart.

Quote of the Week

“Don't aim at success - the more you aim at it and make it a target, the more you are going to miss it. For success, like happiness, cannot be pursued; it must ensue, and it only does so as the unintended side-effect of one's dedication to a cause greater than oneself or as the by-product of one's surrender to a person other than oneself. Happiness must happen, and the same holds for success: you have to let it happen by not caring about it.”

-- Victor E. Frankl

* * *
 We now enter the final month of the first half of the year.  My kids will be out of school soon.  I will spend the entire summer in our Newport Beach office (thank God).  And hopefully, many of you will be grateful to be past graduations, school drop-offs, and whatever else this time of year represents.  I remember loving summer when I was a kid, and I remember in my adult years before I had children not even knowing when it was summer (I worked 18 hours per day and I paid no attention to seasons).  I now know when it is summer, but pretty much only because of my kids' calendars - not mine. Last summer the family and I were in New York most of the summer, and I learned what wearing a suit in humidity every single day was really all about.  This year, I will be in Newport, my kids will have their summer "stuff" going on, and while markets never sleep, I at least will be wearing my suit in the beach-breezy community of Newport.  Working hard all day in a lovely climate with a beautiful family enjoying their summer - it's going to be delightful.

Reach out with any questions or comments you may have regarding Italy, the market, the euro, the beltway, volatility, and more.  And do not hesitate to meet with me and your Private Wealth Advisor this summer. It is to that end that we work.