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Europe: Mourning and Markets

December 6, 2016

“Unsustainable things continue until they stop.” That is how Herb Stein answered Richard Nixon when Nixon asked about economic timing.

The financial and economic construction of the EU and the eurozone has now reached the realm of the unsustainable. Something has to give as the boundaries of policy are stretched toward their outer limits while voters rebel in EU countries as diverse as the UK, Italy, Austria, and Greece.

The EU and the eurozone are being preserved by “extend and pretend” policies. The European Central Bank’s mantra of “whatever it takes” is now replaced by the reality of the limits on NIRP and ZIRP and the EU’s huge and still-growing debt-to-GDP ratio. Debt proceeds are paying for social promises, not amortization of investment for growth.

All this worsens as the financial gaps among eurozone member countries widen. TARGET2 imbalances reported by the ECB reveal the flows of monies moving among eurozone countries. Those numbers are discomforting. Those who can move money (euros) to relative safety are doing so with increasing intensity. Italy loses. Germany gains. But relative safety is not absolute preservation of capital.

European politics is revealing that a major sentiment change is underway. Brexit was only the beginning. Another domino fell with Sunday’s vote in Italy. (See my colleague Bill Witherell’s analysis, which we published Monday: cumber.com/can-italy-be-saved/. The trend is a strong one and is likely to unfold in adverse ways over the next few years, particularly after UK parliamentary action formalizes Britain’s exit from the EU.

The political development in Italy is a probable forerunner to electoral outcomes in France and Netherlands. And Greece festers like a bleeding sore while Germany’s Merkel tries to hang on.

Readers may wish to listen to a Dec. 5 Bloomberg news segment in which I discuss Merkel’s quandary (audio only): “With Election Coming, Merkel Has to Be Tough Here” < bloomberg.com/news/audio/2016-12-05/with-election-coming-merkel-has-to-be-tough-here-kotok>. I also talked about Italy in another Bloomberg segment yesterday. See “Why Italy Is Different for Markets Than Brexit” <bloomberg.com/news/videos/2016-12-05/why-italy-is-different-for-markets-than-brexit>.

Monetary ZIRP and NIRP have decimated the finances of institutional managers of long-lived liabilities while repressing the income of savers. Going more deeply into negative-rate territory is still being quietly discussed in Europe – but is quickly set aside as no longer viable.

Tapering back up to zero is also quietly discussed, but policy makers move tepidly out of fear of a taper tantrum in euro-denominated debt. The violence of the post-Brexit bond rally and subsequent selloff have instilled fear into the psyche of European policy makers, and they now look at the post-Trump US bond rout with added trepidation. In Europe the capital of some financial institutions that have been bludgeoned to own negative-rate paper can be wiped out with a return to positive rates.

Years ago my friend Vincenzo Sciarretta and I co-wrote an optimistic book on Europe. That was in a more salubrious and sanguine time. The euro was new. The spread between Italy and Germany had contracted by 500 basis points. Maastricht was the guiding principle. Systemwide bank deposit protection was under discussion. Those were halcyon days.

Wiley published our book, which took us two years to research and write. Invest in Europe Now! was the title Wiley assigned to it.

The book is now out of date, and all optimism in it has been subsumed by gloom and desperation. Bank deposits are not safe in Europe, as we have seen. Bail-in has replaced bailout. Policy is disparate and in disarray. People party as Rome burns. In Northern Europe geopolitical risk analysts watch Kalingrad and the Baltic.

Regarding the situation in Italy, Vincenzo, a well-respected journalist who has written for Italy’s leading financial publications, had this to say to me in a note yesterday:

“By the way, this No [vote] was a referendum against a bad proposed reform of the constitution, and against the bureaucratic cancer that seems to be growing back in many parts of the West. However, in no way is it a vote against the euro, as I see reported in many international media. Italy will never, ever choose to get out of the euro. It can be forced out, but not of its own choice – simply because, as I have said, most people now depend on public spending.”

There is an old joke about what you get when you play country and western music backwards. You get your dog back. You get your truck back. You get your girl back.

Our old book can now be read backwards. Troubles spread in Europe; cointegration has become disintegration; and politics reveal the pressure.

The experiment of a common currency with an uncommon and dysfunctional body politic is unsustainable. Herb Stein’s warning applies.

Market agents beware. Risk in Europe is rising. We are underweight.
And finally, here is an additional interview with Bloomberg in which I discuss post-election opportunities in the US municipal bond market: “High-Grade Munis Now a Gift in Bond Rout” <bloomberg.com/news/videos/2016-12-05/high-grade-munis-now-a-gift-in-bond-rout-kotok>.

 

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is a commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.

Follow Cumberland Advisors on Twitter at @CumberlandADV.