Italy's referendum on constitutional reforms failed by a wide margin last Sunday, triggering the resignation of cherubic Prime Minister Matteo Renzi and forcing officials to quickly calm fears about the country's debt-laden banking system.
For the third time this year voters in developed countries rejected the globalist status quo - only this time, markets were prepared for the result. While official polling in Italy is prohibited within two weeks of elections and referendums, the "no" camp was firmly ahead at the beginning of the quiet period. The euro zone's third-largest economy is in desperate need of political reform to break systemic gridlock in its legislative process, but by offering his resignation in the case of defeat Renzi made the vote into a referendum on his leadership and the European Union. The only surprise came in regard to margin of victory and turnout. "No" prevailed with more than 59% of the vote while 69% of Italians showed up to the polls. By comparison, less than 60% of eligible voters participated in the U.S. presidential election.
As was the case with U.S. assets following President-elect Donald Trump's victory in November, stocks and the euro initially sold off sharply on the result before quickly turning heavy losses into gains. The FTSE MIB, Italy's benchmark equity index, fell nearly 2.5% at Monday's open before trading nearly 1.5% into positive territory by late morning. Stocks pared gains into the close but still finished in the black. Yield on the 10-year Italian government bond yield at one point climbed 14 basis points Monday before finishing the day only one basis point higher. Pundits fear rising euroskepticism could spill over into Germany and France, but investors for now appear unperturbed. The German DAX and French CAC indexes rallied 1.5% and 1.1%, respectively, on Monday.
While panic did not grip broader markets, concerns did immediately intensify regarding Italy's troubled banking sector. Shares in Italy's most endangered bank, 544-year-old Monte Dei Paschi di Siena (MPS), fell sharply Monday as its rescue plan -- which most considered a pipe dream to begin with -- was thrown into doubt by rising political uncertainty.
Following last week's €1 billion junior bonds-to-stock conversion, MPS still needed to complete the most ambitious part of its private recapitalization plan: raising €4 billion worth of equity, more than 10 times its current market cap. The bank, with a market value of less than €600 million, has already burned through €8 billion of fresh capital in the past four years - not exactly inspiring confidence for a fresh infusion. Further political upheaval following the referendum spooked the deal's €1 billion anchor tenant, the Qatari Investment Fund, making the deal untenable. Senior bankers meeting early this week decided to table the capital raise, paving the way for a public "bail-in" of Monte Dei Paschi.
As mandated by EU rules, state-sponsored bank rescues must include burden-sharing by junior bondholders, which for MPS includes €2 billion worth of retail investment. To avoid the politically disastrous move of imposing losses on middle-class Italian households and pensions, officials negotiated a deal guaranteeing full repayment of the first €100,000 to every junior bondholder. Senior bonds and deposits will reportedly be fully spared while Monte Dei Paschi is still keen on offloading €28 billion worth of non-performing loans through a securitization vehicle supported by a government guarantee. Italy's negotiating hand regarding the flexibility of state-aid rules was no doubt strengthened by concerns about rising anti-EU sentiment across the continent.
The Italian government is also eager to prevent contagion in a domestic banking system saddled with €360 billion worth of sour loans (equal to one-fifth of the country's annual GDP). Unicredit, Italy's largest bank, is expected to reveal plans for a €13bn capital increase next week. While it may be able to scrape together enough hard assets to avoid a public bailout, the future is more tenuous for heavily indebted mid-size Italian banks like Genoa's Carige, Popolare di Vicenza and Veneto Banca.
Monte Dei Paschi asked the ECB early this week to consider a five-week extension of its deadline for completing a private rescue to January 20, but the central bank reportedly denied the request at a meeting Friday. Recognizing the inevitability of Italian bank bailouts, the ECB likely decided to just get on with it. MPS shares were halted three times Friday afternoon, ultimately falling around 13%. Prices of MPS junior bonds were nearly cut in half, from 36 cents to 18.7 cents.
President Sergio Mattarella has asked Prime Minister Renzi to continue in a caretaker capacity until late January when Italy's Constitutional Court reviews electoral law for the country's lower house. At that time, rival parties are hoping for early elections (which aren't scheduled until 2018). The result of Italy's constitutional referendum was unique because it was both a rejection of the status quo (Renzi's pro-EU leadership) and a preservation the status quo (Italy's dysfunctional government bureaucracy). Investors are unworried about the ongoing stasis, but sentiment could change depending on the ultimate fate of Italy's banking sector.
ECB Taper Triggers Latest Bond Tantrum
The European Central Bank (ECB) this week announced plans to reduce the size of its monthly asset purchases, an unexpected move causing bond markets around the world to sell off sharply.
At its much-anticipated policy meeting this week, the ECB voted to extend its quantitative easing program, previously due to end in March, until December 2017. The extension was three months longer than expected, but a reduction in the size of monthly asset purchases (from €80 billion to €60 billion a month) was a bigger surprise. Economists had predicted a six month extension at the current €80 billion a month rate.
Peripheral European bond markets, which shrugged off Italy's failed constitutional referendum Sunday, were the hardest hit following the ECB announcement. By Friday's close yields on Spanish, Italian and Portugese 10-year government bonds had spiked eight, 16 and 34 basis points, respectively, to 1.54%, 2.04% and 3.86%. Even German bonds were briefly put under pressure Thursday, with yields climbing eight basis points to 0.42% (their highest level since January), before falling back to 0.37% Friday. U.S. 10-year treasury yields continued their recent ascent, surging 12 basis points to 2.47%.
ECB Chairman Mario Draghi vehemently fought characterizations of the central bank's move as a "taper," but the bond market had a tantrum anyway. With the Fed preparing to raise rates next week and the ECB moving to a "lower for longer" QE approach, global policy makers are tip-toeing away from the accommodative monetary policy responsible for historically low bond yields. President-elect Trump's election victory has already triggered a $2 trillion rotation from bonds to stocks, but it could be just the beginning of a long-term rebalancing.
China Fails To Stem Tide Of Capital Outflows
China's moves to slow capital outflows weren't enough to prevent foreign exchange reserves from falling sharply again in November.
The communist government's foreign currency stockpile fell another $69.1 billion last month to $3.052 trillion, bringing losses since its peak in June 2014 to almost $1 trillion. Investors are pulling money from the country as the yuan gradually depreciates against a strengthening dollar, which hit a 13-year high after President-elect Trump's electoral victory. President-elect Trump has threatened to label China a currency manipulator for devaluing the yuan when in fact the regime is spending tens of billions of dollars every month artificially supporting its value.
Steady outflows in response to a gradually depreciating renminbi have once again started fueling speculation about a large one-time currency devaluation. Such a move, accompanied by the subsequent promise of stable free market-driven exchange rates, would bring pain to Chinese consumers - and likely draw the ire of the American president-elect - but would remove a cloud of uncertainty hanging over the Chinese economy. A group of advisors with close ties to the Beijing government are said to favor a 20% devaluation. Ripping the Band-Aid off would cause short-term pain for some but allow investors to feel more confident about the currency's long-term direction.
A cheaper yuan would also reignite Chinese exports, which fell sharply for seven straight months prior to November. Last month, however, a weaker currency allowed the country's shipments to grow 0.1% despite expectations for a further decline. Eschewing long-held fears about falling Chinese producer and consumer prices, the communist republic is now also threatening to export inflation. Factory prices jumped 3.3% in November (versus expectations for a 2.3% gain) while consumer prices rose 2.3% (versus expectations of 2.2%).
While China has been trying to curtail rampant cross-border merger activity, apparently the directive doesn't apply to strategic acquisitions in the semiconductor space. President Obama nixed the purchase of German chip maker Aixtron SE by China's Fujian Grand Chip, citing security risks due to the fact Aixtron's technology has military applications. The Chinese government is not happy about it. Lu Kang, a Chinese foreign ministry spokesman, said the proposed acquisition was "pure market behavior," adding "we hope that the United States will cease making groundless accusations about Chinese companies and will provide a fair environment and favorable conditions for investment by them."
Treasury Secretary Jack Lew is also urging Congress to reject a $1.3 billion Chinese of takeover of U.S. chipmaker Lattice Semiconductor for similar reasons. The purchase, as we reported last week, was being made by a firm called Canyon Bridge Capital Partners that appears directly affiliated with the Chinese government. Lattice's two biggest rivals - Xilinx and Intel - make chips used in military technology. U.S. Secretary of Commerce Penny Pritzker warned last month about China's "$150 billion industrial policy designed to appropriate this [semiconductor] industry." China's protestations over blocked acquisitions could be seen as hypocritical (to say the least) given foreign firms are barred from making similar deals in its centrally-planned economy.
Elsewhere in China, the new Shenzen-Hong Kong Stock Connect got off to a sluggish start in its debut. The trading link has been lauded as a "super-connector" between China and the world, allowing international investors to trade 881 Shenzhen-listed stocks up to a daily quota of 13 billion yuan a day and mainland Chinese investors to trade 417 Hong Kong-listed stocks up to a quota of 10.5 billion yuan. However, northbound investors poured only 2.71 billion yuan into the Shenzhen market while Chinese investors put only 850 million yuan into Hong Kong stocks - 21% and 8% of their respective quotas. The debut was a far cry from that of the Shanghai-Hong Kong Stock Connect that launched in November 2014. The daily quota from Hong Kong investors into the mainland exchange was filled within only a few hours of trading.
Russia Seals Rosneft Sale After OPEC Deal
Traders were surprised last week when Russia joined OPEC's deal to cut crude production, sending oil prices soaring. This week we got a big clue as to why Vladimir Putin was motivated to get a deal done.
Russia announced the sale of a 19.5% stake in state-run oil company Rosneft to the sovereign wealth fund of OPEC-member Qatar for more than €10 billion. Commodities trader Glencore (of which the Qatar Investment Authority is the largest shareholder) also chipped in €300 million euros. In a bid to narrow its budget deficit, the Russian government has been engaging in a large-scale privatization program of which the Rosneft sale was a key component. Saudi Arabia, another economy dependent on oil revenue, is pursuing a similar strategy with next year's partial Aramco IPO. Both governments were heavily incentivized to get an OPEC deal done in order to boost prices and maximize the proceeds from their respective deals. Qatar acted as key mediator between Russia and Saudi Arabia during negotiations.
Crude prices digested last week's rally, with U.S. shale companies this week taking the opportunity to hedge. WTI crude futures contracts for December 2017 delivery are now more expensive than those for June 2018, a phenomenon known as backwardation. Traders also remain skeptical about how well the production agreement will be enforced. Crude output from OPEC members rose to a record 34.16 million barrels a day in November, while the new quota is set at 32.5 million. Iraqi and Iranian compliance is the biggest question mark according to Michael Cohen, the head of energy commodities research at Barclays.
On Saturday, OPEC and non-OPEC producers reached a joint agreement to cut production for the first time since 2001. A group of non-OPEC countries will cut crude production by a total of 558,000 barrels per day, short of the initial 600,000 target.
While Saudi Arabia tries to usher in the post-oil era, its citizens struggle to adjust to a more diversified capitalist society.