Italy: Political Fracture Changes Everything

Credit where it's due - Wolfgang Munchau wasn't wrong, even though he was writing in the FT a month ago: 'Judging from the latest opinion polls, the most likely election result is gridlock, perhaps in the form of a Bersani-Monti coalition of the centre-left, possibly with a centre-right majority in the Italian senate, where different voting rules apply. This would leave everyone, more or less, in charge. Nobody would have the power to implement a policy. Everybody would have the right to veto one.'

With a busted political establishment and the EU's 'technocratic' post-democratic settlement rejected, it is difficult to see where Italy's next usable political architecture will be found. It is little short of tragic, since protracted political uncertainty can be expected to undermine and nullify the real gains made in Italy's economic structure during the past few years. More likely, the pay-off of austerity will simply be. . . deepening economic atrophy.

Let's first acknowledge the real gains made.  On a constant-dollar basis, I estimate that by the end of 2012 asset-turns in Italy had been restored to very near pre-crisis levels, albeit at the cost of a capital stock that was shrinking by around 3% a year. In nominal terms, of course, the situation is less attractive: although capital stock is now shrinking by around 1% a year, asset turns on that capital stock have recovered less than half of what they lost during 2008-2009.

More, Italy retains positive cashflow: it had a private sector savings surplus equivalent to around 2.2% of GDP in 2012, up from 0.7% in 2011 and a reversal of the minor savings deficit prior to the financial crash. This savings surplus (calculated as the current account minus the government budget balance), is also a tally of the net cashflows running between the private sector  and the financial system. Capital flight reflecting worries about whether Italy may ultimately exit the Euro may have stripped deposits from  Italy's banking system as a whole, but nevertheless the underlying domestic economy is quietly  generating  a net flow of cash from the private sector and into the financial system.

If this were a normal cycle, this could be an exciting inflection point:  the immediately-negative impact of recession upon returns on capital have been answered by a fall in the capital stock which has allowed asset turns to recover, and (on the constant-dollar reading) to reach pre-recession levels.  Moreover, there is a positive cashflow into the banking system from the private sector savings surplus allowing banks the financial leeway, and commercial incentive, to start extending credit once more. It is precisely at this point that there is both the motive and means to re-start the investment cycle - ie, for recession to be replaced by upswing. This is what normally happens in a business cycle.

But it is at precisely this point that Italy's genuine political instability matters, since it introduces radical policy uncertainty into investment planning. That uncertainty is likely to delay the re-start of investment spending, so the factors of production are most likely to continue to shrink, and with it the economy.  The creative destruction of recession morphs into a simple but protracted shrinkage  of the factors of production.  

And without growth, it is difficult to fashion a path towards debt-stability, given the starting point.
Taking government debt first: at end-2012 the Italian government reckoned its debt as Eu1.988 tr, which was a rise of only 4.3% on the year.  However, since nominal GDP contracted by an estimated 1.1%, the debt/GDP ratio continued to rise, hitting 127%, up from 121% in 2011 and 119% in 2010.

As a result, despite all attempts at fiscal control, the mathematics of continuing to service this debt have become more daunting, not less.  One can illustrate this by calculating the nominal GDP growth rate needed to merely to stabilize current debt levels (ie, by not allowing the interest paid to be capitalized), at recent interest rates. What interest rate? During 2012, 10yr Italian government bonds yields average 5.43%, with a standard deviation of 58bps.  If, generously, we accept a bond yield at the low end of the range (ie, one standard deviation below average), we reach an interest rate of 4.85%.  Quite by chance, that is also the yield which the market is asking today in the wake of the election result: up from lows of around 4.1%.  

Let us, then, consider a range of between 4.1% and 4.85% as representative.  In those circumstances it would require nominal GDP growth of between 5.2% and 6.2% a year in order to stabilize government debt at current levels, assuming no further fiscal deficit and payment of interest rates.

How likely a prospect is that? Even taking the lower hurdle growth rate of 5.2%, nothing approaching that level of growth has been achieved since 2000: the average nominal growth rate between 2001 and 2012 has been  around 2.3%.   Even if that 2.3% nominal growth rate can be attained once again, that will not merely not stabilized the nominal debt, it will not stop debt/GDP ratios continuing to rise.

Without nominal GDP growth, it seems impossible that debt/GDP ratios will stabilize, let alone improve.

The conclusions are grim:

• Italy's recession could have produced conditions in which an investment upturn was likely: indeed, in real terms, contracting capital stock has allowed asset turns to return to pre-crisis levels, whilst the economy generates a private sector savings surplus of about 2.2% of GDP - liquidity which would normally be expected to fund the subsequent capital investment upswing.
• Political fracture and instability are likely to choke off investment spending just at the point when the investment cycle should be responding to rising asset turns and the liquidity generated by a rising private sector savings surplus. 
• The recession is therefore unlikely to heal itself, but rather is likely to turn into a sustained contraction in the factors of production.  
• This is no longer a question of regained international competitiveness, but rather of political roadblocks to cyclical upturn.
• Italy's government debt levels cannot be stabilized without growth.  Government debt to GDP has risen to around 127% of GDP by end-2012, up from 119% at end-2010.
• Even if 10yr yields sink to 1 standard deviation below average 2012 yields (ie, around 4.1%), it would (theoretically) require nominal GDP growth of 5.2% with no fiscal deficit, in order to stabilize current debt levels. 
• Since 2001, Italy's nominal GDP growth has averaged just 2.3% a year. There is no reason to expect it to achieve that under current circumstances. 
• The price of the EU installing a post-democratic 'technocratic' government in Italy is thus extraordinarily high, since its subsequent popular rejection cancels out even those economic and financial gains which might have been made in time.  Italy is back to where it was when the crisis broke, only deeper in debt, and with a weaker structural base to its economy and no plausible political response to its plight. 

Shocks & Surprises Weekly FX Observations

Weekly Caveat Reminder: what follows are merely statistical observations about currency trends and  movements. My belief is that fx markets are, absent exceptional circumstances, usually efficient, which is why no way of forecasting their short-term movements with any consistent success has ever been discovered.  So whilst I believe that these observations are interesting, and that knowing the trend is likely to be useful, if  you trade fx and lose money, you have no right to blame me for any losses (And, sadly,  no justification for the charitable instinct that  I should be rewarded from your profits.)

Watch List / Trend Breaks
Turkish Lira: Joins the Watch List. The strengthening trend in place since mid-Sept came under challenge at the end of last week for the first time since October. It has broken through its floor of 1.7821, but it is too early to say for sure that it has broken trend.
Sterling:  Joins the Watch List for a different reason.  The weakening trend established in mid-January and accelerating strongly since, is beginning to look over-blown: during the last week, the fall came to 3.5SDs above trend - most unusual. The ceiling has fallen to 1.594 to the dollar, but it would be surprising if current levels of 1.516 were not lifted in the coming days.

Strengthening Trends
US Dollar: The strengthening trend against the SDR which has been in place since early-January continues to gather momentum. It is now at its strongest point since July 2010.
Rmb: The very gentle strengthening trend, which has been in place since early Oct 2012, is still in place, without having yet quite morphed into stability.
Euro: The weakness of the last two weeks is not yet sufficient to put the Euro on the Watch List: the strengthening trend which has been in place since mid-Sept is still in place, with the current floor still around 1.31 to the dollar.

Weakening Trends
A$: The weakening trend which emerged in early Feb is still in place. I would not expect it to be stronger than 0.96 any time soon.
Yen: There is no threat to the strong weakening trend, in place since mid-December.  The current ceiling of 85.7 is coming down rapidly.
Gold: The weakening trend established in early January continues to gather pace. The ceiling is dropping quickly, and is now at 1685 to the oz.
CRB Commodities Index: Visuals to the contrary, statistically the index showed a weakening trend since early December, and this is now emerging quite clearly. The index broke 298 as expected last week, and now has a ceiling of 297.

Reading the Zew: Freude und Angst

Yesterday's Zew Survey gave a surprisingly dour reading about the current state of the German economy, but added a  surprisingly positive result about the likely trajectory of the economy over the coming six months in its central  Zew Indicator. How should one read it? Indeed, apart from providing an insight into the mind of the German finance industry, can we learn anything much about the likely trajectory of the German economy.  

In the end, I think we can, but only if we read the survey results with care. The monthly Zew survey presents the views of a relatively small sample of the German financial industry, this month  it had 272 participants. For the 'current views' survey, they are  asked to indicate if they think currently the economic situation is 'good' 'acceptable (normal), or 'bad'. In the event, 18.2% thought it was 'good', 68.8% thought it was 'normal' and 13% thought it was 'bad'. The final reading index is simply the % 'good' (18.2%) minus the % 'bad' (13%), leaving a reading of 5.2 (%).

Similarly, for the headline economic sentiment index (the Zew Indicator), respondents are asked whether they think the overall economic situation will improve, worsen, or remain the same over the coming six months. In the event, 56.8% expect things to improve, 34.6% expect little change, and 8.6% think things will get worse – so the indicator reads a net 48.2.

There are several things to notice about this. First, both questions are subjective: it may be that German financial professionals are constitutionally fairly glum about current circumstances, but basically optimistic that things will get better. And in fact, that's exactly what the survey's history suggests: since 2000, the average reading of the 'current situation' index has been minus 13.5%, whilst the average reading of the 6m economic sentiment index has been +17.9.

But actually, that's misleading: Germany's financial industry isn't routinely glum about Germany's current circumstances, so much as bi-polar, swinging regularly from profound angst to roaringly positive consensus, and back again. To put this in context, the modestly positive readings found in the last four months are quite literally unprecedented this century. The structure of the survey doesn't compel such a result, and this sort of bipolar assessment isn't repeated as dramatically in assessments of the Eurozone as a whole, or the US, or the UK.

There is a conclusion to be drawn: history suggests it is most unlikely that the Zew current conditions survey will survive for long in its relatively phlegmatic state. Rather, we must expect the mood to resolve itself into either deep pessimism or triumphant optimism in the coming months.

The Economic Sentiment (the Zew Index) is a different matter altogether. February's survey was the strongest since Dec 2009. 

Before we welcome this as a precursor of the much-anticipated recovery of Germany leading the Eurozone out of recession, there are three things to understand about the Zew Indicator as it stands:

1. Although it is far more volatile than the 'current conditions' index, it is not significantly bi-polar – a wide spread of views is regularly attained.
2. On balance, the industry is generally optimistic (and why not? Equities do tend to rise over time).
3. These sentiments have no predictive power about how the economy will be experienced in six months time. If it were, one would be able to find some relatively stable relationship between the Current Situation Index which would echo Zew Indicator. In fact, the two are radically different.    
4. In practice, the Zew Indicator by itself is not a good indicator of GDP growth or even direction.

But this raises an important issue of the relationship between the two indexes: clearly the importance attached to the Economic Sentiment index will be a function of how Current Conditions are experienced. A Zew Indicator of 100 (ie, unanimous belief that things will get better) means something quite different if the current conditions index is extremely miserable (say, minus 50) than if it is already quite cheerful (say +50).

One can capture this relativity by adjusting  'how things are going to look' by 'how things are now: ie, one adds the current view to the expectation, to get a clearer idea of where things are going. 

When we do that, we find: 

First, the volatility of the index is contained, and the seemingly rather excessive belief that things generally get better is muted, with the average value since 2000 retreating to +4.4 (rather than +17.9, unadjusted).

Second, Although the adjusted index shows sentiment improved, this improvement does not represent a fundamental breakout from the travails of the last three years that the unadjusted index describes. Rather, this looks like a repeat of the bounce achieved at this time last year.  

Third,  we also find that the adjusted index gains  in explanatory and even predictive power . In particular, it has proved a reasonable indicator of the direction and strength of GDP growth (though admittedly, it's not something I'd want to model from).    

Conclusions: Read properly, then, it seems that the German financial industry, as surveyed by the Zew Institute, does have a pretty keen idea of what's going on in the economy.  So what are they really telling us this month?

1. The bounce in economic expectations is less dramatic than it is initially stated, closely resembling what happened this time last year.
2. The bounce in economic expectations is not yet sufficiently pronounced to compel a significant acceleration in GDP growth.
3. The view that the current situation is modestly OK is historically unprecedented – one would expect it to resolve into either gloom or joyous optimism very shortly.
4. If the Zew is going to be an early indicator of a modest recovery in the German economy, the most crucial thing to watch over the coming months is the 'Current Situation' index, rather than the headline Zew Index.

Shocks & Surprises Weekly FX Observations

Usual caveats apply: the purpose of these pieces is merely to identify trends, measure them and understand when they are under threat. In my view, going the one step further, and forecasting currency values is impossible - the best brains constantly try, and constantly fail.  Still, here are the observable trends:
Trend Breaks / New Trends / On Watch
Rmb: The strengthening trend which has been in place since early Oct 2012 is now very gentle indeed, and perhaps morphing into stability vs the dollar.

Strengthening Trends
US Dollar:  The strengthening trend which has been in place since early January is still gathering momentum. Against the SDR index, the dollar is not at its strongest point since July 2012.
Euro: The strengthening trend has been in place since mid-Sept and is possibly now accelerating. The current floor is around 1.31 to the dollar.
Turkish Lira:  The strengthening trend has been in place since mid-Sept 2013, and is not under challenge. The likely floor has come down to 1.78.

Weakening Trends

Sterling:  The weakening which emerged in mid-Jan is still strongly in place, and still possibly accelerating.  We're unlikely to see 1.60 to the dollar again any time soon.

Yen: No threat to the weakening trend that has been in place since mid-Dec. The ceiling of 84.5 continues to come down rapidly.

Australian Dollar: We identified a new weakening trend last week, and this has been confirmed this week. It seems unlikely it will climb back to 0.96 any time soon.

Gold: The weakening trend which made its first appearance in early November 2012 is gathering pace. Ceiling of 1694 is coming down rapidly.

Commodities: Our belief that the CRB Index had a downward inflection in late November 2012 has been painful. However, it now seems justified, with the Index retreating to around 298, which I would regard as its current ceiling. 

The Shizzle - Japan Bond Maths

The Shizzle Feb 13th, 2013

Why I’m writing:  'The BOJ said that they are increasing buying bonds, but they're also putting power into lowering interest rates. If the economy gets better, then l/t interest rates like a 10yr yield at less than 1% are unlikely. . . . . If we think about the future and if interest rates go up, then 67% in bonds does look harsh. We will review this soon.’   Takahiro Mitani, president of Japan’s Govt Pension Investment Fund (Y108tr in assets).

The evidence:  How much does Japan’s government depend on Bank of Japan, rather than private sector savings surpluses, buying the bonds it needs to float?

Yn tr	2012	2011	2010	2009
JGBs Issued	26.29	27.79	43.03	-10.63
FBs Issued	11.26	14.08	6.03	35.22
Total Supply	37.55	41.87	49.06	24.59
PSSS	15.77	27.53	49.74	13.94
Net BOJ Holdings	23.31	13.28	5.41	9.79
Total Demand	39.08	40.81	55.15	23.73
Demand – Supply	+1.53	-1.06	+6.09	-0.86

JGBs = Japanese Govt Bonds; FBs = Financial Bills; PSSS = Private Sector Savings Surplus; Net BOJ Holdings = Change in BOJ’s holding of JGBs, less changes in govt deposits

Conclusions:

·         In 2012, private sector savings surplus could have bought only 42% of the JGBs and FBs the government needed to sell. BOJ buying was the equivalent of 62.1%.
·         Between 2010 and 2012, annual debt issuance fell by 30.7%, net BOJ buying grew by 76.8%, and the private sector savings surplus shrank by 68.3%
·         Increasingly, Mitani-san’s portfolio, and the ability of PM Abe to finance expansion, depends pretty much solely on what BOJ decides to do next.
·         BOJ gov Shirakawa steps down on March 19^th.  Who his successor is really matters.

Follow up?  If you’d like further analysis, or to argue the toss about the conclusions, please email me on michael.taylor@coldwatereconomic.com

Shocks & Surprises Weekly FX Observations

Although nobody knows how to forecast fx movements with consistent success, a statistical approach to deviations from measured trends does at least allow us to say what is happening now, and when existing trends are under threat. Here are this week's observations, issued with the usual caveats - these are just empirical observations, if you use them to trade, and lose money, don't blame me:

Trend Breaks / New Trends
Australian Dollar: After spending two weeks on watch, A$ movements this week broke the strengthening trend, most probably establishing a new weakening trend.  Do not expect to see 0.96 again any time soon.

Strengthening Trends
US Dollar: Strengthening trend vs SDR in place since early January is still gathering momentum.
Euro: Strengthening trend in place since mid-Sept is not under threat, and is possibly accelerating. The current floor has risen to around 1.31.
Renminbi: The strengthening trend which has been in place since early Oct is still in place, but is perhaps morphing into stability vs the rising dollar. But for the Chinese New Year holidays, this would be a candidate for the Watch List.
Turkish Lira:  Strengthening trend in place since mid-Sept is still in place and not under challenge. The floor is now probably around 1.785.

Weakening Trends
Yen: There's no threat to the Yen's weakening, in place since mid-Dec.  The current ceiling of 84.03 is coming down rapidly. 
Sterling:  The weakening trend which has been in place since mid-Jan is strongly in place and possibly still accelerating. Sterling is not coming back to 1.60 to the dollar any time soon.
Gold: The new weakening against the dollar, in place since mid-December, is not under threat. The ceiling  has now probably come down to 1,701.
Commodities: Despite the run-up of the CRB Index during the last two months, this has not been sufficiently strong to reverse the weakening trend which has been in place since early Dec 2012.  Expect a short-term challenge to around 298.

A Week in Quotes

Global Growth
'It is not that discoveries no longer occur but that the rate has slowed. Without new knowledge, only derivative technologies are possible - and, however, important, they are incapable of sustaining the sorts of economic growth rates the world has enjoyed since the coming of the industrial revolution.' Andre Geim, Nobel Prize winner for his work on graphene, writing in the FT.

Japan Bond Yields

'If the economy gets better, then long term interest rates like a 10 year yield at less than 1% are unlikely. So 'If we think about the future and if interest rates go up, then 67% in bonds does look harsh. We will review this soon. We will being discussions for this in April-to-May. Any changes to our portfolio could begin at the end of the next fiscal year.'  Takahiro Mitani, President of the Government Pension Investment Fund, with Y108tr in assets to manage.

Apple and Unions in China 

'The position of chairman and 20 committee members of the Foxconn Federation of Labour Unions Committee will be determined through elections once every five years through an anonymous ballot voting process.'  Foxconn explains how its Chinese workers will choose replacements for the  c18,000 union committees whose terms expire this year and next. 

Apple and its Cash

'It has a sort of mentality of a depression. In other words, people who have gone through traumas  - and Apple has gone through a couple traumas in its history - they sometimes fell like they can never have enough cash.'  David Einhorn, of Greenlight Capital, urging Apple to disgorge more of its $137bn cash to investors. 

Fiscal Problems: Europe and US

'It's ridiculous sometimes when you look at the kinds of difference we're negotiating: a few billion over seven years. . . '  Luxembourg PM Jean-Claude Juncker on EU budget negotiations.

'Deficits are projected to increase later in the coming decade because of the pressures of an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt.'  Expecting publicly-held federal debt to reach 77% for 2023, 'Such a large debt would increase the risk of a financial crisis, during which investors would lose so much confidence in the government's ability to manage its budget that the government would be unable to borrow at affordable rate.' US Congressional Budget Office.

Shocks & Surprises Weekly Espresso

This week's issue of the Shocks & Surprises Espresso takes a look at the implications of three sets of data:

• US personal income, which rose 2.6% mom in December
• German terms of trade for December, and their implications for the Eurozone
• Japan's 4.8% yoy rise in construction orders in December, including the 52.7% yoy jump in national government orders. 

In each case, I think there are things to be learned by looking at them in a little more detail. The Espresso is delivered in email form, and if you'd like to take a look, email me at michael.taylor@coldwatereconomics.com.

Shocks & Surprises Weekly FX Observations

Last week I explained the methodology behind Shocks & Surprises approach to currencies (here), but the caveats are worth repeating.  No-one knows how to forecast currencies with consistent success, and the ex-post factor economic rationalizations for specific currency movements are all as good, or bad, as each other. All I am trying to do in these pieces is identify current trends and likely changes in them in a way which is consistent, which I've been using for years, and has at least some modest statistical backing. If you trade off them, and lose, it's your own lookout.

Strengthening Trends
US Dollar: continues to strengthen against the SDR as it has since early June, and that trend is not under threat.
The Euro: continues the strengthening trend against the dollar that has been in place since mid-Sept, and is possibly now accelerating.  Currently it's likely floor is around 1.305.
Rmb: The current strengthening trend has been in place since early Oct, and whilst mild, is not under threat.

Weakening Trends
Sterling:  The emergence of the weakening trend in mid-January is strongly in place, and is possibly accelerating. Sterling isn't going to see 1.60 to the dollar again any time soon.
Yen:  There's no threat to the weakening trend that has been in place since mid-December. The current ceiling is 83.2 (ie, it would be a major surprise if it reached this leve), and is rising quickly.
Gold: The new trend of weakening against the dollar is not under threat. The current ceiling is 1,706 an ounce, and falling.

On Watch
Australian Dollar: I put this on watch last week, and it remains there. Whilst it seems clear that the currency no longer has a strengthening trend, it is too early to say whether its replacement will be stability or weakness.

A Week in Quotes

Eurozone - Two Views
'Last year there was a very tense mood here in Davos. This year I think we are seeing sentinment moving from stabilization to recovery, and that means I should get a chance to do some cross-country skiing.'  Olli Rehn, EU Economic and Monetary Affairs Commissioner.

'The ECB has already provided extra refinancing credit to the tune of Eu900bn to commercial banks in countries worst hit during the crisis, as measure by its payment system known as Target. These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now in the same position as private investors. It is guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial'.

And . . . 'The proposal for bank resolution is not a firewall but a 'fire channel' that will enable the flames of the debt crisis to burn through to the rest of European government budgets'.

Finally  . . . 'Asset ownership in bank equity and bank debt trends to be extremely concentrated among the richest households in every country. Not bailing-in these households amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe's taxpayers, social transfer recipients and pensioners'. Hans-Werner Sinn, of the Ifo Institute, writes in the FT.

China's Regulators on Wealth Management Products
'The banking industry's wealth management business has channelled funds that might otherwise flow into high-interest underground loans, illegal fundraising, and commodity speculation and has upheld financial stability'.  China Banking Regulatory Commission's Yan Qingmin. 

'Ninety nine percent of wealth-management products arae normal products, approved by the China Banking Regulatory Commission. Maybe there are a small number that are problematic but that's not a risk to the banking sector.'  Fang Xinghai, DG of Shanghai financial watchdog.

Japan,  FX Policies and Politics
'Europe is in no position to criticize Japan. Europe has brought about a prolonged weakness of the euro as a result of their own policies, whilst Japan has supported Europe through purchases of bonds.'  Yasutoshi Nishimura, Dep Economy Minister.
'To survive and prosper Japan needs to participate in international trade without being encumbered with isolationist ultra-nationalists. Like horses in blinders, they are unable to see beyond their noses.' Sir Hugh Cortazzi, former British ambassador to Japan, and long-standing friend of Japan, worrying about  having nationalist Harkubun Shimomura as Education Minister.

Australia Elections 
'Australia now faces an eight-month election campaign which will mean that some significant investment decisions by business will be put on hold.'  Innes Willcox, CEO of the Australian Industry Group comments on the vote to fix elections for the lower house and half the Senate for Sept 14th.

Taiwan - The Pension Problem Put in Context
'The pension system time bomb won't explode during my term . . . However, the train will definitely fall off the cliff if we don't start building a bridge right now.' President Ma Ying-jeou explains.