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Jelly Donuts

This note was originally published at 8am on June 06, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“A jelly donut is a yummy mid-afternoon energy boost.”

-David Einhorn

 

On a flight to Dallas, Texas yesterday, I was reviewing My Pile and re-read David Einhorn’s Op-Ed from May 3rd, 2012 in the Huffington Post titled “The Fed’s Jelly Donut Policy.” Loved it.

 

I love donuts, burgers, and beers too. What I don’t love is pretty clear – Ben Bernanke’s post 2009 Policies To Inflate rank right up there at the top of my no-love list alongside listening to Giraldo Rivera and watching figure skating.

 

What I also love is the debate. I love to argue; particularly with people that don’t. How else do we hold these charlatans accountable? How else are we going to challenge the perceived wisdoms of their economic policies? How else are we going to evolve and progress?

 

Alongside Ray Dalio (Bridgewater Associates) and Seth Klarman (Baupost Group), I consider David Einhorn (Greenlight Capital) one of the thought leaders of Wall St 2.0. Stylistically, while Einhorn is often compared to Warren Buffett (“value guys”), I think he’s currently  evolving his investment process at a much faster pace. Einhorn does macro – he shorts things too.

 

Einhorn isn’t politically polarized like Buffett has become. He is able to evaluate macro risks objectively (what the Fed should do and balance that with his opposing thoughts of what the Fed will do). He’s embraced Behavioral Finance, writing openly about fear and greed. He also understands that the stock market is not the economy, and that “valuation” is not a panacea.

 

On Bernanke’s failed policies, here’s my abbreviated version of Einhorn’s Op-Ed:

 

“The blame lies in his misunderstanding of human nature. The textbooks presume that easier money will always result in a stronger economy, but that’s a bad assumption… it is simply misguided thinking that persists among the Fed Chairman and other government ivory tower thinkers. They do not understand or relate to the prime component of capitalism and a free market: greed.”

 

“The Fed does not understand investor psychology: if you want to get people to sell bonds and buy stocks, the best way to do that is to show them that bond prices can, and do, fail… there is nothing that slows the economy faster than rising oil prices… In light of this, I cannot understand why we are even discussing let alone hoping, for Qe3.”

 

Agreed, Mr. Einhorn. Agreed. Hope is not a risk management process. Neither is doing more of what didn’t work. Enough of the yummy intraday stock market rallies on iQe4 upgrade rumors already. After 3 of these suckers, Americans have a “tummy ache.”

 

Back to the Global Macro Grind

 

Strong Dollar = Deflates The Inflation = Stronger Consumption. That remains our bull case for not only the US and Global Economy, but for their Equity market multiples.

 

Yesterday’s US Services ISM report (May) was one of the most constructive we have seen on the Prices Paid front since December:

  1. US Services ISM of 53.7 (May) vs 53.5 (April) stopped slowing – that’s better than bad
  2. Prices Paid (within the ISM Services report) dropped -7.1% month-over-month to 49.8 (vs 53.6)
  3. Employment dropped -6.2% month-over-month to 50.8 vs 54.2

So, employment is bad and getting worse. But A) you know that B) so does the bond market and C) employment is a lagging (as opposed to a leading), indicator. Real-time market prices are also leading indicators.

 

In other words, if you are begging for Bernanke’s iQe4 Upgrade this morning, you are begging for prices paid to go back up at the pump – and you are begging for the leading indicator on real (inflation adjusted) economic growth to continue to slow.

 

Begging isn’t leadership. It’s un-American.

 

Our process hasn’t changed in scoring how the real world works. Unfortunately, neither has the Washington and Old Wall Street consensus. These people don’t have a risk management process. This is what they do. So it will be very interesting to see how the political pressure for Bernanke to bailout everything from Europe to Morgan Stanley looks in the coming days and months.

 

Bailing out Europe through the Washington, DC based (and US tax payer backed) IMF? Yep, I’m thinking Einhorn will lead from the front and have a few things to say about that too.

 

In the meantime, the SP500 recapturing our long-term TAIL line of support (1283) yesterday should be as bullishly received as it was bearish when it snapped on the downside.

 

Yes, “risk” changes faster than you can bang back another Jelly Donut. That is the game we are in, so play it.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, and the SP500 are now $1597-1636, $96.21-103.11, $82.03-83.35, $1.22-1.25, and 1268-1306, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Jelly Donuts - Chart of the Day

 

Jelly Donuts - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – June 20, 2012


As we look at today’s set up for the S&P 500, the range is 33 points or -2.13% downside to 1329 and 0.30% upside to 1362. 

                                            

SECTOR AND GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 1

 

THE HEDGEYE DAILY OUTLOOK - 2

 

THE HEDGEYE DAILY OUTLOOK - 3

 

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: on 6/19 NYSE 2074
    • Up from the prior day’s trading of 539
  • VOLUME: on 6/19 NYSE 772.04
    • Increase versus prior day’s trading of 9.16%
  • VIX:  as of 6/19 was at 18.38
    • Increase versus most recent day’s trading of 0.33%
    • Year-to-date decrease of -21.45%
  • SPX PUT/CALL RATIO: as of 6/19 closed at 1.54
    • Up from the day prior at 1.51 

CREDIT/ECONOMIC MARKET LOOK:


TREASURIES – all the while, the bond market doesn’t care. Makes sense because the bond market has had what we have had right since March – more Qe slows growth. 10yr yield at 1.63%, up a whopping 5bps for the week and remains in a bearish formation with all 3 risk mgt durations of resistance overhead. 

  • TED SPREAD: as of this morning 38
  • 3-MONTH T-BILL YIELD: as of this morning 0.09%
  • 10-Year: as of this morning 1.63
    • Increase from prior day’s trading at 1.62
  • YIELD CURVE: as of this morning 1.35
    • Up from prior day’s trading at 1.33 

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: MBA Mortgage Applications, June 15
  • 10:30am: DoE Inventories
  • 12:30pm: FOMC Rate Decision
  • 2pm: FOMC Releases Projections of Economy and Fed Funds
  • 2:15pm: Bernanke holds news conference on FOMC 

GOVERNMENT:

    • Federal Open Market Committee concludes 2-day meeting
    • Interior Dept. auctions oil, natural gas leases in 39m acres in central Gulf of Mexico
    • House, Senate in session
    • Senate Banking subcommittee holds hearing on ordinary investors, IPO process
    • Senate to vote on EPA air toxics rule
    • House Education, Workforce panel holds hearing on multi- employer pension plans, with treasurer Kroger, CEO of Arkansas Best, 10am
    • House Financial Services panel holds hearing on “Market Structure: Ensuring Orderly, Efficient, Innovative and Competitive Markets for Issuers and Investors” 

WHAT TO WATCH: 

  • Fed seen extending Operation Twist, avoiding bond buying
  • News Corp. makes A$2b bid to double stake in Australia pay- TV
  • Procter & Gamble cuts quarterly forecasts
  • Interior Dept. auctions oil, natural gas leases in 39m acres in central Gulf of Mexico
  • Greek leaders poised to agree on three-way coalition
  • King sought GBP50b QE extension in BOE vote defeat
  • Quest Software accepts sweetened $25.75-shr bid from Insight
  • Chevron among bidders seeking leases near BP spill site
  • J.D. Power new-car survey to be released
  • Senate to vote on air-toxics rule; BGOV Insight
  • MSCI releases annual market-classification review
  • MSCI seen passing over Taiwan, S. Korea for upgrades 

EARNINGS:

    • JinkoSolar Holding (JKS) 6:37am, CNY(5.16)
    • Actuant (ATU) 7:30am, $0.59
    • Micron Technology (MU) 4pm, $(0.21)
    • Steelcase (SCS) 4:01pm, $0.13
    • Clarcor (CLC) 4:02pm, $0.70
    • Red Hat (RHT) 4:05pm, $0.27
    • Bed Bath & Beyond (BBBY) 4:15pm, $0.84
    • Apogee Enterprises (APOG) 6:30pm, $0.03

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG

 

COMMODITIES – nice big rip right back up to where Commodities can resume their bubble popping – if Bernanke doesn’t deliver the drugs today, that is. CRB Index has a stiff immediate-term TRADE line of resistance at 279. Oil, Gold, and Copper are red this morning. The bet was on what people would beg for, not that he’d actually deliver on the bet. 

  • IPad Boom Strains Lithium Supplies as Prices Triple: Commodities
  • JPMorgan Poised to Make 157% Return on MF Global’s LME Shares
  • Copper Declines as Fed May Opt Against Further Bond Purchases
  • Oil Drops a Third Day in London on Supplies Before Fed Decision
  • Cotton Futures Extend Gains After Surging 6% Yesterday on China
  • Sugar Retreats After Reaching a Two-Month High; Cocoa Declines
  • Oil in Production Conundrum on Saudi-Iran Split: Energy Markets
  • Rio Tinto Commits $4.2 Billion to Expand Iron Ore Production
  • Gold Seen Falling a Second Day in London Before Fed Decision
  • Soybeans Climb as Dry Weather Persists, Threatening U.S. Supply
  • Palm Oil Surges Most in 15 Months as Dry Weather Boosts Soybeans
  • Japan Passes Sovereign Insurance Bill for Iran Crude Imports
  • Hedge Funds Hurt in Third May Commodity Rout as Brevan Drops
  • Copper Declines as LME Stockpiles Expand
  • Indonesia Reducing Palm Oil Tax Seen Delaying Shipments to July
  • Record Soybean Prices to Spur Indian Farmers to Boost Sowing
  • Ivory Coast Cocoa Growers Returning to Farms After Attacks 

THE HEDGEYE DAILY OUTLOOK - 4

 

 

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - 5

 

 

EUROPEAN MARKETS

 

THE HEDGEYE DAILY OUTLOOK - 6

 

 

ASIAN MARKETS


CHINA – evidently every man, woman, and child in China doesn’t yet have a tv to watch the circus of people begging for more of what slows real-inflation adjusted growth (Qe); the Shanghai Comp didn’t cooperate with the “news” yesterday, closing down on the session (-0.3%) and remains broken across all 3 of our risk management durations #GrowthSlowing.

 

THE HEDGEYE DAILY OUTLOOK - 7

 

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - 8

 

 

 

The Hedgeye Macro Team



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100% Cash

“Duration neglect is normal in a story, and the ending often defines its character.”

-Daniel Kahneman

 

I’m a storyteller. So are you. We tell ourselves, our families, and firms stories every day. We tend to frame each story within the framework of how we think. How we think drives our decision making. In the end, we are all accountable for those decisions.

 

I made a decision to go to 100% Cash in the Hedgeye Asset Allocation Model yesterday. That’s a first. If you’ve been reading my rants for the last 5 years, I don’t have to explain why at this point. You know where I stand. I do not think that this ends well.

 

Some people think that it will end just fine. Some people think doing more and more of what has not worked is the only way out. Many people thought the very same thing in 2008, and the moneys in their accounts are still underwater to prove it.

 

Back to the Global Macro Grind

 

You can call me short-term. You can call me the longest of long-term. You can call me whatever you want – that’s all part of the storytelling too. I was never supposed to be a name in The Game. The Old Wall was never supposed to fall.

 

The Old Wall used to get away with making up Perma characters in their storytelling. Someone was always the Perma Bull. Someone was always the Perma Bear. Some of us call that fiction. Some of us just permanently manage risk, both ways.

 

I have by no means perfected the risk management process. The day that you think you have is the day you are about to get clocked. The plan is always grounded in uncertainty. The plan is always that the plan is going to change.

 

As The Game changes, the process evolves. Sometimes the process signals that it’s time to just get out of the way.

 

To review why I am already out of the way this morning:

  1. I have no idea what our Central Market Planner in Chief is going to say
  2. If Bernanke delivers the Qe3 drugs, food/energy inflation will slow real growth further
  3. If Bernanke doesn’t deliver the drugs, a world full of Correlation Risk comes into play

In other words:

 

A)     You cannot beg for Qe and have Accelerating Growth at the same time – the world needs growth, not more debt

B)      If you do not get Qe, the US Dollar stops getting debauched, and Commodity Bubbles continue to pop

 

So that’s why, at this time and price, I have a 0% asset allocation to Stocks and Commodities. Why I have a 0% asset allocation to Currencies and Fixed Income is simply because I know how to manage my immediate-term risk.

 

I sold both our US Dollar (UUP) and US Treasury (TLT) positions before yesterday’s plundering. That doesn’t mean I cannot buy either of them back. There are no centrally planned rules associated with how much Cash I can be in. At least not yet.

 

Back to the #1 thing that Bernanke will not mention today that is driving both causality and correlation in real-time market pricing – The Correlation Risk. Here’s how the last 2 months of Correlation Risk between the US Dollar and everything “risk” has looked:

  1. SP500 = -0.91
  2. Euro Stoxx600 = -0.96
  3. MSCI World Index = -0.95
  4. CRB Commodities Index = -0.94
  5. WTIC Oil = -0.94
  6. Copper = -0.93

No matter what storytelling they continue to feed you (and they is all encompassing at this point, from the Old Wall to Washington, DC and Paris, France), this is all that matters right now.

 

Get policy right (causality), and you’ll get the US Dollar right. Get the US Dollar right (correlation), and you’ll get a lot of other market things right.

 

We’ve been right 32 out of 33 times since firm inception (2008) on the US Dollar. That’s probably why I haven’t spent the last 5 years trying to get back to a bull market top break-even. I may be wrong this time. If I am, I’ll at least know why.

 

European central planning storytellers have played their hands. In my own accounts, with 100% liquid Cash (and illiquid Hedgeye stock), I’m holding a hand of kings. For their last no-volume hurrah, Bernanke Beggars better hope he has 4 aces.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1, $94.84-97.59, $81.32-81.97, $1.24-1.27, and 1, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

100% Cash - Chart of the Day

 

100% Cash - Virtual Portfolio


HedgeyeRetail Visual: JCP: Far from Over

On the heels of CMO Mike Francis’ departure, Ron Johnson was cited in the press highlighting that Q2 sales have picked up relative to Q1 today. They better be. While investors aren't in this one for the quarter – Q2 comps get much tougher in the back half. This quarter is far from over…

 

HedgeyeRetail Visual: JCP: Far from Over - JCP COTD

 


Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out?

Conclusion: Certainly, Italy isn’t Spain or Greece, but Italy does have a massive amount of debt, some €400 billion, that needs to be refinanced over the coming 12-months, which we believe is major pressure point for Italy.

 

Positions in Europe: Short EUR/USD (FXE)

 

With eyes focused on Spain’s recent €100B credit line to recapitalize its banks and investors digesting the results of the Greek elections over the weekend, we thought it important to contextualize the macroeconomic imbalances and risks in Italy. Italy has long been grouped squarely as a member of the PIIGS, and is a country we’ve persistently signaled as the largest potential risk threat in Europe, due in particular to the size of its economy, as the seventh largest global economy, the fourth largest in Europe, or the third largest in the Eurozone.

 

The main glaring risk threats that could propel Italy down the path to become Europe’s next domino is the size of country’s outstanding debt (at €1.9 Trillion or 120% of GDP); the mountain of debt it has to roll over in the next 12 months (nearly €400 Billion); and the market’s cracking credibility around PM Mario Monti’s ability to reduce the country’s fiscal footprint and spur growth.

 

Further, and as we show in the charts below, fear around Italy’s creditworthiness, which has recently been expressed by near cycle highs in sovereign CDS spreads and government yields on the 10YR, fall on some rather glaring negative fundamentals over recent quarters and years:  declining GDP over the last three consecutive quarters; a rising unemployment rate (especially among its youth); deterioration in labor market competitiveness; and increased competition for export goods to its key trading partners.  And while figures such as retail sales have held up relatively well (at least YTD compared to the Eurozone), we largely see the number supported by declines in the savings rate and the extreme growth in consumer credit, which we expect to revert to the mean; Service and Manufacturing PMI figures show a decidedly negative trend and we don't see the underperformance versus the Eurozone aggregate materially rebounding over the intermediate to longer term.  We also expect FDI to roll over in step with this contraction.

 

Specific to risk signals, Italy’s 10 year yield remains elevated around 6%, with 5 year CDS trading at 546bps, or just under Spain’s CDS at 614bps. We believe all this spells increased pressure on the Italian economy to grow over the next 3-5 years. Not only will Italy, like all EU members, see spillover effects from economic weakness throughout the region—as most countries main trading partners are fellow EU members—but the higher cost to service its debt will put more pressure on politicians to raise taxes to meet funding requirements, all of which will put further downside pressures on the overall economy.  And this comes at a time in which Monti’s credibility in parliament is shaking and foot power (strikes and riots) remains strong across a populous that is largely against austerity.

 

One savings grace to keep in mind when assessing Italy is that its public deficit stands at -3.9% of GDP as of last year compared to Spain’s at -8.9%. Italy may in fact be compliant with the Growth and Stability Pact limit of -3% by 2013, yet we think the road will be challenged.  When one combines the challenges of issuing austerity, the higher cost to service debt, and the spillover effects from struggling peer economies with a tighter credit environment, Italy is likely to shoot below its growth forecasts this year and next, while heightened default fears may call Eurocrats to act on a bailout that is greater than the capabilities of the existing bailout facilities. As we discuss in our conclusion, Eurobonds may be the only viable solution should the market’s fear of Italy’s sovereign and banking risks reach a precipice.  

 

By the Charts:

We think contextualizing the macroeconomic imbalances and risks in Italy can best be expressed through charts and select commentary:

 

 

Debt’s Drag - We begin by looking at Italy’s debt profile. At 120% (as a % of GDP) –the second highest in Europe behind Greece—its debt servicing load will equate to €400 Billion over the next 12 months alone.

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 1

 

 

Growth Slowing - As the data from Reinhart and Rogoff shows, when a country’s sovereign debt load exceeds 90% (of GDP) growth is dramatically impaired. We think the market will continue to punish Italy via higher servicing costs, and we do not expect the 10 year yield to dip materially below its current level of 6% over the intermediate term.  Italy has already seen three consecutive quarters of negative GDP. Over the last 10 years on an annualized basis, GDP has averaged 2%. We see Italy undershooting IMF growth forecasts of -1.8% in 2012 and -0.3% in 2013.

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 2

 

 

Debt Maturities High - Italy has an extremely aggressive debt schedule to roll over in the next 12 months. The remaining 2012 debt due (Principal + interest) = 70% of GDP. This compares to 49% for France; 45% for Spain; 23% for Germany in the remainder of 2012. On June 14th Italy sold its max target of €4.5 billion of 3-7-8 year bonds, however the 3 year averaged a yield of 5.3% vs 3.91% on May 14th, or a 36% premium in one month! We’d expect a similar trend of filling demand through higher yields into year-end should we not see any “bazooka” from Eurocrats. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 3

 

 

Too Big to Fail? - The answer to this question is unequivocally YES under the present bailout facilities. If we consider Italy’s outstanding debt and tack on another €272.7 Billion of borrowing from the ECB (chart below)—without even mentioning the potential bailout needs for Italian lenders crippled with sovereign holdings—it’s apparent that the remaining funds of the EFSF (around €200 Billion) plus the €500 Billion from the ESM that is expected to come online on July 1, 2012 (assuming, in particular that Germany’s Parliament signs off on it on June 29th), is undercapitalized to handle an Italian bailout, and fallout across the region from the failure Italy. [EFSF guarantees: Germany 29.07%; France 21.83%; Italy 19.18%; Spain 12.75%]   

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 4

 

 

Deficit Dual – Italy’s deficit stands at -3.9% of GDP as of 2011. This rate, compared to Spain’s -8.9%; Ireland’s -13.1%; Portugal’s -4.2%, and may be the country’s a saving grace.

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 5  2

 

 

Fiscal Consolidation – However, Italy’s path forward on fiscal consolidation has been anything but clear and orderly. The corruption and standstill of the Berlusconi government was obvious; yet the technocrat government of PM Mario Monti is also marked by disunion.  For one, while Monti has promised the market big fiscal cuts, they’ve yet to all be ratified by the Italian Parliament. Below we present the web of promises.  On June 15th the Italian government moved forward with a package worth €80 Billion to spur economic growth, including selling states assets and reducing public spending. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 6

 

 

Risky Profile - Italy is showing a similar risk profile to Spain. Here we chart the spread over German bunds.

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 7

 

 

Underperforming Growth - A major leading indicator for growth is derived from PMI surveys. As the two charts below indicate, Manufacturing and Services PMIs are well under the Eurozone averages and have been under the 50 line that divides expansion (above) and contraction (below) for more than 10 and 12 straight months, respectively. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 8

 

 

Labor Cost Inefficiencies - A major factor behind Italy’s slower growth profile is stagnation in its productivity, witnessed by higher unit labor casts, while wages, despite declines, have yet to turn negative. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 9

 

 

Industrial Production –Slowing and underperforming continued.  In a recent European Commission paper reviewing Italy, the report noted that stagnation in production is the key factor behind Italy’s loss of cost competitiveness since the euro adoption. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - CC. 10

 

 

Trade Balance Improvement – On a positive note, since early 2011 Italy has become less and less of a net importer. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 11

 

 

Exports Mismatch – However, export growth has also slowed, providing less of a benefit to the top line. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 12

 

 

Export Breakdown – Italy has high specialization in textiles, clothing, metal, and minerals, but due to the relatively small size of Italian firms, Italian exports to its main EU trading partners have found increased competition over the last decade.  Further, its increased share in non-EU countries (particularly Eastern Asia) has yet to reap full benefit.   [Main export partners: Germany = 13.1%; France = 11.6%; Spain = 5.3%] 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 13

 

 

New car registrations - Yet another metric we follow. Here again, no surprise, underperformance vs the EU average. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 14

 

 

Smashed Piggy Banks - The Italian household savings rate moved from a high of 17.8% in mid 2002 down to 11.6% as of Q3 2011. The chart shows that Italians leveraged their savings in the upturn and in the downturn. The tapping of savings in the last three years demonstrates to pay off debt and the resilience of the Italian consumer to maintain previous spending levels. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 15

 

 

Consumer Credit Drying Up – As the pace of consumer credit has slowed, retail sales have still remained resilient, especially in the year-to-date period. Here Italy has shown a positive divergence over the Eurozone since the start of the year based on a 3 month average compared to the previous year.  We chalk this up the sticky levels of consumer credit, and continued draining on savings.  

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 16

 

 

Unemployment Hooking - Another grave dynamic is the underemployment across Italian youths at 39%. While short of the 50.2% for Spanish youth, combine “a lost generation” with Italy’s demographic headwinds of an aging population (near oldest in Europe) and you have a cocktail that puts great pressure on social services, and the debt and deficit loads in the years ahead. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 17

 

 

Square Stagflation - While we expect inflation to moderate into the back half of 2012, sticky stagflation (and negative real yields) has been a theme across much of the globe as energy prices remain elevated in the weak dollar environment. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 18

 

 

Risk Lines in the Sand - From a risk perspective, we turn to both government yields and CDS spreads. Both are tracking hockey stick moves. 

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 19

 

 

Spreads Pressure Banks - Finally, we show that Italy’s 10s-2s spread is not helping the banks and is another indication of the dampened growth outlook by investors. We’ve shown the timing of the two 3 month LTROS, in December ’11 and February ’12, respectively as reference points. Interestingly, while the first LTRO gave a boost to the spread, the market to a negative reaction the increased liquidity from the 2nd LTRO, as the insolvency of banks became the focus and it was not clear that “the injection” was actually being circulated throughout the economy, witnessed by extremely high levels of euros being parked at the ECB’s overnight deposit facility.  

 

Italy Isn’t Greece or Spain, But Is Italy Next To Be Bailed Out? - cc. 20

 

 

It’s no great secret that risk has shifted quite precipitously from peripheral to peripheral over the course of the last two years (with the longest stay in Greece) in what has been called Europe’s sovereign debt and banking crisis. However, when we discuss the bailout needs of Italy, the largest economy of the PIIGS, we’re talking about risks (disruptions) to continental and global economies that inevitably lead one to the question: Is Italy too big to bail?

 

Over the last years we’ve seen Eurocrats, under the support of Troika, coming to aid the sovereigns at every step: Greece, Ireland, Portugal, and now Spain. Unfortunately, we think Italy is far too large to rescue. In short, we believe the only way out over the intermediate term is the issuance of Eurobonds, a position the Germans are against, and rightfully so in our eyes for they do not wish to take on Italy’s credit risk.

 

After all, why would a German give an Italian use of his credit card carte blanche?

 

Clearly, Europe’s back is against a wall, as member countries are unlikely to post more capital upfront for bailout facilities (and here the IMF may have to take on a much larger role outside of its mandate). But what we fear, and the market may not understand, is that there is no “bazooka”, no panacea, to cure Europe’s collective sovereign and banking risks in one shot. Surely, the threat of an Italian default leads us down a road of even higher uncertainty on Europe’s go-forward, all of which portends that the downside in European capital markets is not fully priced in. 

 

Could the next two years look like the last two years? We think the answer could be a qualified yes, however making such calls is reckless given that the direction of Europe changes on a nearly daily basis.  For now, the fate of Italy, along with the rest of Europe, will be wrapped in the hands of Eurocrats. The main topics on the table include: a Fiscal Compact; a Pan-European Deposit Insurance; Eurobonds; a European Redemption Fund; the terms of passage of the ESM (and EFSF); and a European Financial Transactions Tax. There’s obviously a lot on the table; we do believe that Eurocrats wish to maintain the exiting Eurozone fabric. We’ll be monitoring the developments at the Eurogroup and EcoFin meeting on June 20-21 and the EU Summit in Brussels on June 28-29 to take our cues.

 

 

Matthew Hedrick

Senior Analyst


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