Business World

Wednesday 20 June 2018

The markets will bite back against ECB dinosaurs

'While their balance sheet is in theory limitless, the confidence of markets is not.'
'While their balance sheet is in theory limitless, the confidence of markets is not.'

Paul Sommerville

The situation in Italy, which has settled for now, cannot be taken in isolation. There are financial fires breaking out everywhere but not many are joining the dots. Deutsche Bank, the world's fifth biggest, 13 months ago launched an €8bn rights issue to fill yet another hole in its balance sheet, its fifth capital raise since the global financial crisis.

Deutsche currently holds a derivatives book estimated near €50 trillion - yes, trillion. Only weeks ago it announced another profit warning and a series of mass lay-offs. Its share price has fallen by nearly a third this year to a lifetime low.

Last week it traded below the level hit when a crisis of confidence hit the bank in late 2016 and it looked like it would not survive. Its market capitalisation is now just €20bn, its share price 90pc below the 2008 peak. Any re-emergence of a market crisis in Italy will send this systemically important bank closer to insolvency. Any rebellion in Italy is thus likely to be quashed fiercely. Central bank policy has created a "zombified" banking sector across Europe but the underlying causes of the great financial crisis have never been addressed. Along with the Italian domestic banks, French and German banks hold the most Italian debt.

Meanwhile, in emerging markets, financial crisis is in full flow. Brazil's stock market has lost a quarter of its value in just four months. Turkey is in meltdown and Argentina is turning to the IMF for assistance as its currency plummets and inflation rates explode. Its currency lost 18pc in first 9 days of May and the Central bank put interest rates to 40pc.

Vietnam's stock market, which only last month traded at a record high, has fallen 23pc in the last month. Indonesia and South Africa are showing strains also. The catalyst is a rapid appreciation of the dollar. Since February it has risen 8pc versus the euro, for example, and much more against some of the emerging market currencies. Countries that have external borrowings in dollars find it more difficult to pay back.

In tandem, global trade is slowing. A host of important measures of international trade have suddenly weakened.

Financial markets are beginning to contemplate that the so-called synchronised "growth spurt" is starting to look like a synchronised slowdown. A global trade war would not help.

But underpinning all this is the simple fact that we are now beginning to see the negative consequences of quantitative easing and what happens when central banks try to withdraw from this ludicrous monetary experiment. The tsunami of liquidity has created massive malinvestment and a distortion of all asset prices.

Some of those asset prices are beginning to be repriced. We are entering an era of quantitative tightening and it is important to see the Italian debt in this light. The US has been first to raise interest rates causing demand for dollars and causing problems for everybody else.

Last week it was reported that the EU crisis is back as Italian bond yields have soared. However, they are rising from farcically low levels. Three weeks ago the Italy two-year bond had a negative yield, meaning investors who lent Italy money were paying Italy for the privilege. The Italian 10-year bond has moved from 1.78pc to 3.18pc over the past month.

Yes, a huge move in percentage terms but it would be wise to recognise that Central banks have completely broken any true pricing of bond markets across the globe. These rates are not extraordinary. It is what has gone before that is the aberration.

Argentina, a serial financial basket case, now running to the IMF for support, only last year issued a 100-year bond in US dollars very heavily demanded. By 2018 Greece could borrow two-year money cheaper than the US. Iraq, Ukraine, Senegal, Ivory Coast have all issued bonds at yields that make little sense.

The crucial element regarding Italy is the scale of the problem. Its total debt of Italy is €2.3 trillion, or 132pc of GDP. It is the world's third largest debt pile. The ECB (on your behalf) owns 20pc, foreign investors hold 35pc and Italian financial institutions own 41pc.

The Italian Treasury plans to issue roughly €250bn in bonds this year. So Italy is heavily dependent on the confidence of markets and the support of the ECB.

The Italian banks are flooded with these bonds and bought another €6.5bn this week. It is a free bet for them - if there is a problem they go bust anyhow.

However, the ECB has also got a problem as it is running out of ammunition at exactly the time it is likely most going to be needed. The ECB balance sheet (a polite way of saying euro they created out of thin air and bought bonds with) reached a fresh high this week of €4.562tr. This is 41pc of total EU GDP - an astonishing number.

While their balance sheet is in theory limitless, the confidence of markets is not.

They have signalled they wish to end the quantitative easing programme but any crisis in Italy will lead to further balance sheet expansion and a test of their credibility. They currently own nearly €400bn of Italian government debt.

It has been suggested that any new election in Italy will be in truth a referendum on the euro but this is simplistic nonsense and patently incorrect. At the forefront of voters' minds in Italy is immigration. The more populist parties have been able to ride a wave of discontent over the migration crisis.

The EU's inability to deal with this issue has fuelled anti-EU sentiment. Five Star Movement, the most popular party, in fact campaigned on retaining the euro. However, it must be noted dissatisfaction with the EU in general (rather than the currency) is substantial and growing.

Unemployment and youth unemployment in particular are crucial issues. At a rate of 38pc it is easy to see how young people are turning towards alternative politics. They have been let down by domestic politics and the EU. The health of the economy and poor living standards are also pivotal issues. The economy has been in a coma for many years and how the EU has managed economic issues is considered by voter's part of that problem. This then feeds into dissatisfaction with the single currency. Parties that promoted measures to raise living standards, such as an unconditional basic income, did particularly well last time.

New elections might have lead to an increased majority for Five Star and Lega and a showdown with the ECB. However the EU institutions will try to hold firm. They have no choice. Italy is "too big to bail". The EU elites have shown when trouble starts, Euro treaties are violated, monetary principles are ignored, and democracies get suspended. It will be the same again. Any threat to leave the single currency or default on debt and the EU will unleash measures that will severely damage Italy. In those circumstances, Italian politicians are likely to blink first.

Those focused on Italian politics to determine where world markets will eventually go, I would venture, are missing the big picture.

In the movie Jurassic Park a misguided bioengineering industrialist believes he can tame nature. The chaos theorist recognises there is no way the fragile status quo created can hold. The industrialist, overconfident and clueless, does not see that he has created a monster and cannot contemplate the true picture.

Central banks through quantitative easing have created a false reality that cannot hold - financial markets will eventually reassert themselves, most probably violently. Whether Italy is the catalyst remains to be seen. Most likely it will be just one of many fires that will emerge as the world financial system adjusts to a new reality.

The plastic water cup on the dashboard is vibrating now.

Paul Sommerville is the CEO and head of Advisory of Sommerville Advisory Markets

Paul.sommerville@sam.ie

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