Blain’s Morning Porridge – Oct 17^th 2023: Biden, Putin and Jet Diplomacy – Italy signals the next European Debt Crisis

“The most certain way to succeed is always to try just one more time..”

Biden’s trip to Israel and Jordan vs Putin’s to Beijing – which will prove more meaningful? Meanwhile, Italy’s latest tax cuts and spending plans mimic the Trusterf*ck, but Meloni seems to have got away with it – for how long?

This morning, nothing so clearly illustrates how geopolitical fault-lines are hardening as President Biden making the Trip to Israel and Jordan (meeting the Palestinian President Abbas, President Sisi of Egypt and King Abdullah), even as Tzar Putin makes his obedience to Emperor Xi in Beijing.

Which would you bet on?

• China is struggling with post-growth-transition, a domestic credit crisis, a property meltdown, overlaid by an approaching crushing demographic crunch. Putin is there to give heft to China’s $1 trillion Belt & Road $1 infrastructure/debt programme – which has spent plenty of cash, created severe reputational damage for Chinese overseas lending, and is already looking tired and jaded.

Or

• The USA may be struggling with populism and broken politics – but even some of my rabid Republican supporting chums think Biden is doing the right thing. His trip may achieve little, but signals Biden is willing to flex US leadership.

The above sketches are overly simplistic, but make the point. America might be a mess, but if its China vs USA… then you’d be daft to vote on anything except the Shermans in terms of future wealth creation potential. But, ask me that question again in December 2024. Seriously. Ask it again.

Smart global leaders across the developing world know their challenges are multiple: how to create future growth, stable economies, job creation, stability and wealth. Do they go with China – effectively signing up for the apparently easy option, a quick fix but with many consequences? Or do they do the hard yards, reform their economies, and suffer the indignity of US business consultants waving PowerPoint presentations at them? This is the big question for many nations. And who knows what happens tomorrow – that is why the world is so uncertain and confused today.

This is a topic for a future porridge – Pathways to growth. Capitalism or China-ism? And overlay it with some climate-change issues, and politics!

Meanwhile, back on continent of the aged… from my perspective the big story this morning should be Italy. It’s the Canary-in-the-coal mine highlighting a potential second European debt crisis.

Yesterday, Premier Giorgia Meloni announced a €24 bln package of tax cuts and government worker salary rises to boost the economy. It will increase government borrowing by €16 bln. Further spending plans are balanced by rising excise duties and charging foreigners a flat rate of €2000 to use Italy’s health service – apparently. Her plan is to stimulate domestic consumption at a time when the ECB is trying to combat inflation. Er…

Surprisingly the 10-year Italian Bond spread vs German Bunds actually tightened – to 199 bp following a spike over 200 when the package was announced. Although Meloni has clearly taken a leaf out the Liz Truss book of fiscal dereliction – I was frankly surprised the market didn’t immediately spank Italian bond prices lower (thus pushing yields higher.) Just a few weeks ago, the bund/BTP spread was 175 bp. Why is not widening? Then I remembered. The ECB must be the largest holder of Italian government debt – just saying, but in illiquid markets anything is possible.

Just under 11 years ago, in November 2012, 10-year Italian government debt looked utterly unsustainable at 7% yield and 126% debt/GDP ratio. Then the market expected a potential default, a messy compromise. or even the uncertainty of Italy exciting the Euro. (At one point there was a rumour a German note printing firm was already printing new-Lira notes! Back in the early 90s, I was originating Lire denominated bank bonds with coupons in excess of 15%!) The situation was only resolved when ECB President Mario Draghi’s promised to do “whatever it takes” to restore order – which basically meant the ECB buying the Italian BTPS float, and taking over the direct funding of Italy. Yields quickly fell to 5% and then traded down in line with Europe’s zero interest rate policy.

Today, Italian yields are back up testing 5% again. The debt/GDP ratio is trending towards 140% by year end. (Which is down on 144.4% following Covid last year!) But, Italy’s fiscal deficit is headed towards 5.6%, above its announced 4.3% target – which was already well about the EU’s fiscal deficit limit of 3%! Something has to give.

Why doth the European Commission not complain? As we are all aware, but politely ignore, the problem of the Euro is the lack of any real fiscal agreement/concordant between its members. (Don’t say fiscal union, it only upsets ECB and EU/EC officials.)

There are vaguely acknowledged (and dodged) fiscal rules about Debt to GDP levels. Since 2012 I’ve been watching the ECB insert itself into the Sovereign Debt funding process – winning rights to allocate recovery funding to the member states in the pandemic. It’s not terribly democratic – but it controls the picture. Ultimately the ECB would like a single European government bond market (which would be fascinating in scale and potential liquidity), but it would largely be financing Europe’s high-debt South with transfers from pensions rich Northern nations – unlikely to prove a vote winner for pro-EU political parties.

Italy’s demographic crisis does not help. Its pension bill is the largest in Europe – and is growing fastest. Other nations in trouble with demographics, for instance Japan, have the advantage of being Financial Sovereign Nations. Japan has successfully funded itself via its JGB bond market (some 225% Debt/D+GDP) ratio. Normally this would raise a crisis, but the key issues are:

• Japan owns the printing press and controls to print button.
• It has kept rates effectively at zero meaning the cost of money is zero.
• It has been able to keep the Yen competitive despite zero interest rates (only now coming under mild pressure).

In short, despite its massive debt, Japan illustrates a great example of the Virtuous Sovereign Trinity – a stable currency, a sustainable bond market and boringly, dull, predictable competent politics.

Apply the same tests to Italy and you can’t. It does not control interest rates or its currency. It is effectively a sovereign credit (not a financially sovereign nation). It’s spread is entirely vulnerable to its political competency and how well it addresses the crisis of an ever more expensive debt load. (Many commentators yesterday spoke of Italy’s interest payments increasing by €13 bln per annum because of higher rates.)

Yesterday’s noise out of Rome was a rearranging the deckchairs on the deck of Titanic moment in the great game of financing Europe. Italy is a medium sized, low-growth nation on the soft-underbelly of Europe, with a host of economic issues to solve – which it can’t do as a sovereign nation because it does not control its currency or rates… Not the least of these problems is its massive outstanding debt load. Yet, any solution requires a European-wide Fiscal Solution. Will that ever be agreed?

This is going to run and run… and I have few expectations of a smooth process or outcome.

No Time for Five Things

Bill Blain

Market Strategist