The world’s oldest bank is in the process of negotiating a recapitalization. The market is concerned investors will balk at the proposed plan and throw Banca Monte dei Paschi into bankruptcy, triggering a collapse of the Italian economy and the ultimate demise of the European Union.
Most investors are busy asking themselves what will happen to the Italians if the deal doesn’t get consummated. Yet as is too often the case, they are looking at the problem from the wrong angle.
Instead of worrying about the Italians, the market should worry about the Germans and the other creditor nations within the EU. John Paul Getty, from Getty oil fame, once quipped that if you owe the bank $100 then that’s your problem, but if you owe $100 million, then that’s the bank’s problem. Obviously thanks to decades of irresponsible Central Bank monetary policies, numbers that small now seem quaint, but you get the idea.
And if there was ever a case of a borrower owing so much that it is the lender’s problem, then it’s Italy.
But wait, doesn’t Italy owe money in the form of sovereign bonds? Yup, they do indeed. In fact Italy has the third largest bond market in the world. But although Italian sovereign debt is also a long term issue, that’s not the problem handcuffing the Germans.
No, I am talking about the Target 2 balance. Although the ECB is the European Union’s Central Bank, each nation still has their own Central Bank, there is still a Bank of Portugal, a Bundesbank and even a Bank of Italy. These Central Banks are the conduit between the nation’s commercial banks and the ECB. These regional Central Banks conduct monetary policy on behalf of the ECB. The problem is that monetary policy is set for the European Union area as a whole, and money flows freely between nations.
Creditor nations like Germany deposit their balances at the ECB which in turn lends them out to debtor nations like Italy. This credit or debit is known as the Target 2 balance.
The target 2 debit balance for Italy is €355 billion. So although Italy has plenty of problems, so does Germany. Italy’s monetary mess is so intertwined within the European financial system, an Italian banking crisis will quickly reverberate through Germany and the rest of the EU.
Over the past few weeks German officials have been busy threatening all sorts of penalties if the Italian government bails out their banks. Well, they can threaten all they want, but Italy has way more negotiating power than Germany believes.
Here is my prediction. Italy will get a deal done. It might not “technically” comply with Germany’s restrictions, but the Italians will pass it nonetheless. Italy will tell Germany to go pound sand and will save their banks.
And who can blame them? It’s ridiculous that the Europeans have put off clearing out the bad debts and recapitalizing their banks. A big part of the reason why the US economy has performed so much better coming out of the great financial crisis has been America’s willingness to take the losses within the banking system, put in some new money and drive on. Germany has to stop handcuffing the European economy with all these draconian rules and clean house. Although I am not optimistic that Merkel & Co. will change stripes anytime soon, I suspect the rest of Europe is waking up to what needs to be done.
So even though there are a bunch of scary headlines crossing the tape about Italy’s coming bankruptcy, those are just the stuff of child nightmares. Italy will save their banks. It will be ugly, and there might be some dicey moments. After all, even the American government didn’t pass TARP on the first try. But at the end of the day, Germany will capitulate and allow Italy to save their banks.
Yet in the meantime, all this fear effects markets. This constant overhang of worry about the future of the European Union has created one of the largest pricing anomalies seen in the last decade.
In a desperate attempt to revive their sagging economy, the ECB has pushed monetary policy into the realm of the absurd. Not only have they taken short rates to Katherine Heigl crazy negative levels, but they are engaging in a quantitative easing program that ventures out the risk curve and buys corporate bonds and other non-sovereign fixed income assets.
In doing so, they pushed fixed income to the moon, while equities are busy sucking wind because everyone is worried about the coming collapse of the EU. The divergence between these two asset classes has created a situation where the spread between the two types has never been wider.
It has never made more sense for a European company to issue debt and buy back stock.
Although most now forget, the previous five years saw the exact same thing happen in the United States. Corporate managers were busy issuing record amounts of debt while doing ever bigger amount of stock buybacks. All the hedge fund managers who are now eagerly chasing stocks, previously issued all sorts of apocalyptic warnings about the huge collapse we would experience once the buy back finished (how ironic the hedgies would be the ones buying it at the end). I distinctly remember all the research about the lack of any “real recovery” in the economy and all the reasons stocks would collapse once the buyback arb finished.
This stock market rise even in the face of terrible economic forecasts will be the exact same thing that will happen in Europe. Except the European mis-pricing between debt and equity is even more pronounced.
Buying European stocks and shorting European debt is the best trade on the board. It’s the kind of trade that will work for years to come. European bonds are stupid expensive and on a relative basis, stocks even more ridiculously cheap.
And don’t think the market hasn’t started to figure this out already. Since the Trump election do you think the S&P 500 or the Eurostoxx 50 has risen more? Surprisingly, they are tied.
Over the past month, even though there continues to be all sorts of terrible headlines out of Italy, European stocks have trounced American ones.
Step back and look at how over extended this European fixed income outperformance / stock underperformance truly is:
I know this chart is far from perfect as I should have duration adjusted the bond futures, but it gives a broad brush picture of the extent of the trends.
European bonds versus American ones have been rising for years, while the stocks have seen the exact opposite phenomenon. Europe cannot allow this to continue. Negative rates are killing their financial system. It is causing huge strain on savers.
Ignore all the worries about Italy. Instead focus on that funding gap. And don’t forget, the same hedge funds who were bearish on US stocks for the past few years are the ones warning you off Europe today.
Thanks for reading,