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Manish Singh, CFA | Chief Investment Officer

Crossbridge Capital

VeniceSummary

Italy, the beating heart of the European Union (EU) has gone from being a cheerleader of the Euro to a vociferous opponent. The market has taken note of a potential crisis brewing in Italy as a new populist government takes office. The yields on the Italian sovereign bonds (BTP) are rising and if you are looking to insure against a default, you will have to pay more to protect yourself against default on Italian bonds than Russian government bonds. That’s because, at €2.3 trillion, Italian sovereign debt is 132% of Italy’s GDP. Italy’s problems are lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. The average annual rate of growth per head in Italy, since the adoption of the Euro in 1999, has been zero. Therefore, an Italian born in 1999 who just turned 18 and has become eligible to vote for the first time, has seen nothing but economic stagnation during his lifetime. Yet, Italy is no Greece. Italy’s GDP at €1.7 trillion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy can not only survive outside of the Euro, it can thrive. The European Central Bank is nearing the technical and political limits of Quantitative Easing, and the growth in the Eurozone is slowing down. If yields keep rising and growth doesn’t pick up, it is likely Italy will relapse into an insolvency spiral. If Rome is then asked to submit to austerity for a second time, it will likely take matters into its own hands. The Euro experiment, therefore, may be nearing its end.

What doesn’t kill you makes you stronger?

Immigration, populism, economic malaise (interrupted by brief periods of economic growth), a threat of US tariffs on European Union exports and Brexit – all have already made life quite tiresome for the EU. Now, to top it all off, Italy is back in the headlines.

The Eurozone almost unravelled in 2012 under the strain of the Greek crisis and it took a determined and sustained intervention from the European Central Bank (ECB) – “whatever it takes to save the Euro” and large scale purchases of Eurozone nation sovereign bonds, to douse the fire. The ECB has so far bought €2.4 trillion of debt as part of its Quantitative Easing (QE) scheme and its balance sheet as a percentage of GDP stands at over 40% – larger than the US Federal Reserve’s balance sheet has ever been. Yet, these moves have proven to be just a band-aid and not a cure for the ills that ail the Eurozone. The economic misery has not gone away – higher debt, lower growth, stagnation in living standards, huge imbalances between nations and a high youth unemployment rate persist. The ECB is nearing the technical and political limits of QE. The market has taken note of a potential crisis brewing in Italy, the Euro is falling and the yields on Italian sovereign bonds (BTP) are rising. The yield on the 10 year BTPs has risen almost 50% in the last eight weeks from +1.7% to +2.35%. If you are looking to insure against a default you will have to pay more to protect yourself against default than on Russian government bonds. It is therefore highly likely that Italy with €2.3 trillion of debt (132% of Italy’s GDP) will relapse into an insolvency spiral once the next global recession hits. If so, Rome will not submit a second time to German austerity demands. It will take matters into its own hands. Italy is no Greece.

Italy’s GDP at €1,716 billion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy’s problems are a lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. Italy can not only survive outside of the Euro, it can thrive. The next recession in the Eurozone may prove to be its final, when Euro countries need to run larger deficits to support their economies. Friedrich Nietzsche, the German philosopher wrote in Götzen-Dämmerung (or “Twilight of the Idols”) – “what does not kill me makes me stronger.” A trauma can be transformative and imbue a can-do ethos to make one stronger. The trauma of 2012 has sadly not been transformative for the Eurozone, as it just papered the cracks in its structure. In this instance therefore, the Nietzsche quote more likely paraphrases to – what doesn’t kill you makes you dangerously weaker.

Italy is one of the founding members of the EU and the signing of the Treaty of Rome on March 25, 1957, created the European Economic Community, the forerunner of today’s European Union. The chart below on the left indicates how the Euro dream has soured in Italy and the chart on the right indicates how the Euro, which was supposed to challenge the hegemony of the US dollar has actually lost and continues to lose ground, battered by a series of crises in the Eurozone. In a new working paper titled “International currencies and allocation“, Economists Matteo Maggiori, Brent Neiman and Jesse Schreger examine $27 trillion of global portfolios and conclude that investors overwhelmingly prefer bonds denominated either in their own currency, or the US dollar. The US dollar’s share of cross-border borrowing has climbed to 62% of global portfolios in 2016 from 45% in 2008, mostly at the expense of the Euro.

Market Viewpoints May 2018 Graph

Italy, the beating heart of the European Union has gone from being a cheerleader of the Euro to a vociferous opponent, and it’s no surprise why this has happened. Research conducted by the independent Bruegel Institute indicates that the average annual rate of growth per head in Italy between 1999 (the adoption of the Euro) and 2016, has been zero. If we add the data for 2017, we’d still be at approximately zero. For comparison purposes, that of Spain has been +1.08%, France +0.84% and Germany +1.25%. Therefore, an Italian born in 1999 who just turned 18 and becomes eligible to vote for the first time has seen nothing but economic stagnation during his lifetime. In the February Market viewpoints, I discussed the reasons for continued economic misery in Italy. Having its own currency back i.e. control of monetary policy, would of course not be a sufficient condition for improving Italy’s economy (let alone its long-standing structural problems), but it is a necessary one.

Meanwhile a group of 154 German economists have slammed President Emmanuel Macron of France’s Eurozone reform agenda, calling it “great risks for European citizens.” Under ideas put forward by Macron amongst others, the currency union should introduce a Eurozone Finance Ministry with a budget of its own. In a letter to the German newspaper Frankfurter Allgemeine Zeitung , the economists warn against further expanding the European Monetary and Banking Union and turning it into a “liability union.” The economists call on the German government to “return to the basic principles of the social market economy,” and to ensure progress be through structural reforms and not new credit lines and incentives for “economic misconduct.” Without an ever closer union and transfer of wealth in return for greater control on national budgets, the survival of the Euro is at risk and the dream of forming the United States of Europe is just that – a dream. You cannot have a single interest rate and currency without economic alignment on everything else. It simply doesn’t work. A full transfer union would be deeply unpopular and highly unlikely because that would be at the expense of Germany, France and Netherlands, making them poorer, for the benefit of the weaker countries in the Eurozone. The Euro experiment, therefore, may be nearing its end.

In a 1997 article on the Euro, Economist Milton Friedman, the Nobel laureate wrote: “Monetary unity imposed under unfavourable conditions will prove a barrier to the achievement of political unity.” Recent developments in Italy promise to provide Eurosceptics their “I told you so” moment, or will it? For many Europeans, the Euro symbolizes Europe. As the Greek crisis has shown, as hard as living with the Euro was (and still is) for the Greeks, they feared life without it would be worse and therefore the populist Syriza government passed on the opportunity to take Greece out of the Euro. Are the Italians different? We will soon find out.

Markets & the Economy

Yesterday, the US Federal Reserve (Fed) released minutes of its Federal Open Market Committee (FOMC) meeting held on May 1-2. The minutes stated, that if the US economy performed as expected, “it would likely soon be appropriate for the committee to take another step” in raising interest rates. The estimate for US real GDP growth for the 2Q 2018 is in the range of a robust +3.3% to +4.1%. At the time of the May meeting, the US unemployment rate had held steady at +4.1% since October last year. The US jobs report for the month of April, released after the May FOMC meeting, showed that the US unemployment rate had fallen to +3.9%. The Fed’s favourite inflation gauge – Personal Consumption Expenditure (PCE) has also hit the crucial +2% level, while the core PCE (which exclude the volatile food and energy sectors), has risen to +1.9%. I, therefore, expect the Fed to raise rates by +0.25% at its next FOMC meeting on June 12-13. This will take the benchmark federal-funds rate to a range between +1.75% and +2.0%. This is good news for savers and retirees as well as good news for US Dollar Floating rate bonds, which will continue to be a good investment as short term rate keeps rising. I expect the Fed to raise rates at least once more time thereafter, perhaps in September i.e. with the Fed fund target rate finishing the year in the range of +2.25% to +2.5%

Meanwhile, in the Eurozone, the data has started souring and there is still a trade tariff dispute with the US to resolve. The annualized growth rate in Germany, the Eurozone’s engine, in 1Q 2018, halved to +1.2% from +2.5% in the fourth quarter of last year. The Eurozone as a whole grew at an annualized rate of +1.6% in the first quarter, down from +2.7% in the fourth quarter of last year. The Eurozone runs a vast current account surplus equivalent to +3.6% of its GDP, which means it is highly reliant on foreign demand to fill its factory order books. Any imposition of tariffs or non-tariff barriers that cut Germany, Italy and France’s export to the US and indeed other parts of the world, would be devastating to the Eurozone. Underlining Germany’s vulnerability to external shocks, the last time international trade seized up, in 2008, its economy shrunk by almost -5% in a year.

The indication is that the China-US trade backdrop is improving. US Secretary of State Steven Mnuchin said last weekend – “this is a trade dispute, it was never a trade war” and implied that the US and China continue to negotiate towards a grand compromise. The US wouldn’t be imposing tariffs on Chinese goods for the time being. Washington and Beijing published a joint statement following two days of talks. The tone remains cordial and there seems to be a commitment and willingness to reaching some sort of a compromise. You will recall we discussed US-China trade spat in the March Market Viewpoints where I wrote – ”the world’s two largest economies – US and China – have their fates inextricably linked. They complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities. Therefore It is my firm belief that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one.I see China opening itself up more to US exports.” China has just announced that it will reduce its import tariff on autos from 25% to 15% starting July 1 in a concession to U.S. trade complaint.

The US Economy is on a solid footing. The risk of a recession in next 12 months is negligible. I, therefore, continue to hold US overweight position in equities. It’s also great to see the market is catching up with solid 1Q earnings, which we have seen in the US.

The S&P 500 Index (SPX) earnings per share (EPS) estimate stands at approximately $159 for 2018 and $174 for 2019. So a 15x EPS multiple on 2019 earnings means an SPX level of 2610. The SPX, therefore, will find it hard to go below 2600, barring a major growth decline. The SPX is more likely to trade in the 2750-2800 range going forward, than 2600. Most definitely – do not sell in May and Go Away! Buy, Hold and Stick around instead. I continue to be overweight US equities with sector preferences for Technology (XLK), Financials (XLF) and Healthcare (XLH).

The HealthCare sector particularly has taken a severe beating this year and stocks are trading at a very attractive earnings multiple. Research shows that healthcare stocks have outperformed the market over the past 50 and 90 years, and offer faster earnings growth, a much higher average return on equity, and the lowest earnings volatility. Besides, as an ageing society, consumers are likely to continue to spend more on healthcare over the coming decades. Data released last week indicates that American women are having children at the lowest rate on record, with the number of babies born in the US last year dropping to a 30-year low. If the present demographic trend in the US continues, it points to a society ageing fast. In 1900, there were 10 people under the age of 18 for everyone at or over 65. In 2016, that number was down to 1.6. If the trend continues, by 2042, those aged 65 over will pass those aged 18 and under and by 2060, there will be 1.1 people over 65 for every person at or under the age of 18.

In terms of stocks I like: JP Morgan (JPM US), Bank of America (BAC US), Citi (C US), VISA (V US), Blackrock (BLK US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Schlumberger (SLB US), Halliburton (HAL US), WallGreenBoots (WBA US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Eiffage (FGR FP), Pepsi (PEP US), LVMH (MC FP), Honeywell (HON US), General Electric (GE US), Activision Blizzard (ATVI US)

Best wishes,

Manish