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This note was originally published at 8am on October 22, 2014 for Hedgeye subscribers.

“The Italian people are tired of this corruption. Because we have too many people that steal, too many people that put the money in his pocket. We have 40% of people who don’t pay tax. Can you imagine? 40%. It’s unbelievable.”

-Renzo Rosso

Renzo Rosso is an Italian and founder of the Diesel jeans brand. He appeared in a 60 Minutes segment on Sunday titled “Saving Italy’s History Becomes Fashionable” that showed how he along with a number of other prominent Italian fashion houses (Tod’s, Fendi, Bulgari) were donating millions to repair and improve the country’s historical landmarks, from the Colosseum and the Spanish Steps in Rome to the 400 year old Rialto Bridge over the Grand Canal in Venice.

Why? Because the government is too broke to allocate funds to maintain the country’s historic treasures.

While the issues of deep corruption and oversized bureaucracy in Italy remain nothing new, it’s both telling and remarkable to see these individuals and companies take a stand (now), rather than pointing fingers or pushing the problem on to somebody else further down the road.

All Boxed In - z. colosseum

Back to the Global Macro Grind

If only the Italian government could take a similar stand and unilaterally agree to reform itself… NOW.

As we’ve noted in previous work, Italy recently joined France as a standout in the camp of “Austerity Is Dead” in submitting 2015 budget plans that extend out its initial fiscal consolidation targets.

Specifically, Italian PM Matteo Renzi presented a budget last week that included cuts to labor taxes and personal income taxes worth €18 Billion, however some €11 Billion of it will be funded with extra borrowing that will raise the country’s deficit-to-GDP to 3% this year versus its previous target of 2.6% (with 2015 forecast as 2.9%).

And so for the first time in history, the European Commission may exercise its power to reject both Italy’s and France’s budgets and ask for new ones.  A formal resolution is expected to come on October 29th.

What’s clear is that the 39 year old young-gun and reform-minded Renzi has inherited a challenged position and the country is looking for leadership to pull itself out of what will be three years of negative growth:

  • He filled a power vacuum in February 2014 composed of splintered and diverse parties (that legacy continues and challenges reform)
  • Italy has a record high youth unemployment rate at 43% (3rd highest in the Eurozone behind Spain and Greece at 50%+) and an aggregate unemployment rate of 12.3% vs Eurozone 11.5%
  • Italy has put little dent in its record high debt of 133% (2nd highest to Greece’s in the Eurozone and 3rd highest of all countries in the developed world) vs Eurozone at 92% (that remains a persistent threat to raising debt/increasing interest rate costs)

Yet as we described in an Early Look note on 10/10 titled #EuropeSlowing – Austerity Is Dead? the main “rub” throughout the Eurozone is a leadership one. 

On one hand, we have the ECB and European Commission pointing its finger at the member states to do more country-level reforms. On the other hand, we have member states (like Italy and France) saying they’ve already done a significant level of reform and collectively pointing the finger back at the ECB for not doing more to inflect the lack of growth and deflation they’re experiencing.

To fuel the fire, tack on the indecision created by the fiscally conservative Germans calling into question the potential negative consequences that could result for the ECB’s newest policy toolkit, including the TLTROs, ABS and covered bond buying programs. Just in the last few days we’ve heard whispers (because the information is private) that the ECB bought French, Italian, and Spanish covered bonds, ahead of ABS purchases and the second round of the TLTRO program that are slated to begin/issued in December.

We’ve been clear in our research, including in our Q4 Macro theme of #EuropeSlowing, that we do not see Draghi’s Drugs arresting the low levels of inflation in the Eurozone (CPI currently is at 0.3% Y/Y) nor producing sustainable economic growth (recent programs baked in and with record low interest rates).

As we show in The Chart of the Day below, not only do we think that Draghi’s inflation policies will not work, but we expect deflation to hit Italy (CPI at -0.1% Y/Y) and the other countries across the periphery harder, which should only further push out growth expectations and limit business and consumer confidence. 

If Renzi’s Reform is to ever become a success, it will be counted in many years, not many months, and our opinion is that regaining competitiveness within the confines of the Eurozone structure is a sisyphean task.

Our bottom-up, qualitative analysis (e.g. our Growth/Inflation/Policy framework) indicates that the Eurozone is setting up to enter the ugly Quad4 in Q4 (equating to growth decelerates and inflation decelerates).

From an investment position we continue to recommend shorting Italian (EWI) and French (EWQ) equities (down -7.6% M/M and -8.1% M/M, respectively) and shorting the EUR/USD (FXE) (down -1.2% M/M).

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 2.09-2.24%

SPX 1830-1947

RUT 1037-1115

DAX 8508-9103

USD 84.84-86.16

EUR/USD 1.26-1.28

Matthew Hedrick

Associate

All Boxed In - z. neu CPI