Month: December 2016

A furious Iran threatened to retaliate early Friday against a U.S. Senate vote to extend the Iran Sanctions Act (ISA) for 10 years, saying it violated last year’s deal with six major powers that curbed its nuclear program.  The ISA was first adopted in 1996 to punish investments in Iran’s energy industry and deter its alleged pursuit of nuclear weapons; it was due to expire on Dec. 31. Lawmakers said the extension would make it easier for sanctions to be reimposed if Iran violated the nuclear settlement. The extension was passed unanimously on Thursday.

While US officials said the ISA’s renewal would not infringe on Obama’s landmark nuclear agreement (which may or may not be voided by Trump), and under which Iran agreed to limit its sensitive atomic activity in return for the lifting of international financial sanctions that harmed its oil-based economy, senior Iranian officials took odds with that view. Iran’s nuclear energy chief, Ali Akbar Salehi, who played a central role in reaching the nuclear deal, described the extension as a “clear violation” if implemented.

“We are closely monitoring developments,” state TV quoted Salehi as saying. “If they implement the ISA, Iran will take action accordingly.”

Iran’s most powerful authority, the Supreme Leader Ayatollah Ali Khamenei, warned in November that an extension of U.S. sanction would be viewed in Tehran as a violation of the nuclear accord.

“Iran has shown its commitment to its international agreements, but we are also prepared for any possible scenario. We are ready to firmly protect the nation’s rights under any circumstances,” Foreign Ministry spokesman Bahram Ghasemi said in comments reported by state news agency IRNA.

The Senate’s vote will have political consequences as well: the U.S. Senate vote was a blow to the more moderate and pragmatic Iranian President Hassan Rouhani, who engineered the diplomatic opening to the West that led to the nuclear deal, and may embolden his hardline rivals ahead of presidential election next year. Khamenei and his hardline loyalists, drawn from among Shi’ite Muslim clerics and Revolutionary Guards, have criticized the deal and blamed Rouhani for its failure to deliver swift improvements in living standards since the lifting of international sanctions in January.

It was not immediately clear what form any eventual retaliation for the U.S. Senate vote might take.

Influential Friday prayer leaders, appointed by Khamenei, strongly denounced the ISA extension and called on the government to take action, according to IRNA.

According to Reuters, Iranian lawmaker Akbar Ranjbarzadeh said Iran’s parliament would convene on Sunday to discuss a bill obliging the government to “immediately halt implementation of the nuclear deal” if Obama approves the ISA, the Students News Agency ISNA reported. Another lawmaker quoted by the semi-official Tasnim news agency said Iran’s parliament planned to discuss a bill that would prevent the government purchasing “American products”.

Until today, the White House had not pushed for an extension of the sanctions act, but had not raised serious objections. Congressional aides, cited by Reuters, said they expected President Barack Obama to sign the extension.

However, moments ago, the White House did opine, and according to a Reuters headline, Obama is expected to extend the Iran sactions, in effect not only jeopardizing his own Nuclear treaty…

• OIL PRICES EXTEND GAINS AFTER WHITE HOUSE SAYS EXPECTS OBAMA TO SIGN BILL EXTENDING IRAN SANCTIONS

But potentially opening the way for the reimposition of oil sanctions on Iran. While it is unlikely that sanctions could return while Obama is still president, after the Trump inauguration it’s a different matter entirely, as explained earlier this month in “Will Trump Send The Price Of Oil Soaring” by eliminating as much as 1 million in Iranian output from the world market.

To be sure, crude oil was certainly excited on the news, jumping to the highest price since July 2015.

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By Stefan Wieler from Goldmoney. The full text with additional charts can be accessed as PDF here

 

Since the recent US elections gold prices in USD have sold off 7% and prices are down 13% from the year’s highs. This has led some market commentators to declare this as a turning point in the renewed upward trend in gold prices that began last year. In this note we analyze the recent move in prices within our gold price framework with specific focus on three questions:

 

1. Have gold prices moved in line with changing fundamentals (change in long-dated energy price, central bank net purchases and most importantly, real rates)?

 

2. If not, what is the market pricing in? And more importantly, if prices are in line with fundamentals, what is priced into fundamentals?

 

3. How far can this go if fundamentals move further against gold?

 

Within our gold price framework, we find that the decline in the gold price was in line with the rise in real rate expectations. The recent move in the gold price came mainly on the back of rising real-interest rate expectations (measured by 10 year TIPS yields) as longer dated energy prices remained roughly at and central banks in aggregate have continued to increase holdings (the Russian central bank was a large buyer again in October). TIPS yields had dropped to negative territory again in summer this year as the FED kept delaying the promised interest hikes. Heading into fall, TIPS yields began to gradually move higher to around 10-15bps in October in anticipation of a FED hike in December. However, the day after the election, TIPS yields rallied sharply to currently 50bps. The move in real-interest rate expectations came on the back of a move in nominal rates. 10 year Treasury yields climbed 100bps since the trough in July, half of that post-election alone (see Figure 1).

 

 

In the context of our model, the move in gold prices is slightly larger than what would have been predicted. Our gold price model predicts roughly a USD120/ozt drop in price from the recent peak on the back of the 60bp move higher in real-interest rates. However, prices declined by around USD170/ozt. Consequently, current prices are roughly 5% below our model predictions (see Figure 3), roughly 1 standard deviation of the model error. While this is within the normal error margin of the model, we also believe that the model might also not pick up the full extent of move in rates. For example, we use 10 year TIPS yields as input variable for real-interest rates expectations. Gold prices however likely reflect information over the entire rate curve. We believe that expectations further out in the future carry more weight, but the short end of the curve does matter as well. And the move in shorter maturity bonds was nothing short of spectacular, with 1 year yields reaching levels not seen since 2008. Hence we conclude that the sharp move lower in gold prices is more or less in line with fundamentals.

 

 

This market reaction to the election outcome tells us that expectations are now for a goldilocks scenario of stronger economic growth, stable inflation and partial normalization of interest rates. One can argue that the economic agenda of president elect Trump – deregulation, tax cuts, and infrastructure spending – will promote economic growth. But the latter two will also – all else equal – increase the budget deficit and thus lead to a higher debt burden. A higher debt level combined with higher rates would put further pressure on the budget deficit. This, combined with potential government spending spree, should get market participants worried about inflation. Yet while nominal rates have rallied sharply, breakeven inflation expectations have only moved toward the FEDs target of 2%. Hence, it appears that the market is currently pricing in a perfect outcome, where the interaction of all involved factors cancel out all negative effects:

 

1. The shift to fiscal stimulus, lower taxes as well as the boost to business confidence will lead to high economic growth for years to come;

 

2. The resulting increase in tax revenues will be large enough that the increase in spending (infrastructure) and loss in revenues (taxes) doesn’t’ meaningfully increase the budget deficit and thus debt issuance. The increase in nominal GDP will ensure that government debt/GDP actually shrinks;

 

3. This allows the FED to raise rates despite the higher debt servicing costs…

 

4. Which in turn keeps inflation pressures at bay that would otherwise arise from increased debt issuance and infrastructure spending1

 

The result of this is that real-interest rate expectations can rise which is negative for gold prices. The problem with this scenario is that it is also the only scenario in which real-interest rate expectations can move significantly higher and thus gold lower.

 

Aside from the obvious inconsistencies how the four arguments could interact with each other, this scenario does not allow for any exogenous shocks. Importantly, even under the Goldilocks scenario, the downside for gold would still be limited. Assuming that economic growth plays out in a way that allows the FED to raise rates as planned, the FEDs own forecast is currently for terminal rates of only a mere 2.85%. According to the FEDs own forecast, it will take several years to get there. Arguably FED funds rates are currently 2% below the 10 year Treasury yield and thus as the FED continues to raise rates, 10 year Treasury yields could go much higher. But historically, when FED Funds target rates peaked, 10 year Treasury yields were roughly at the same levels. FED funds rates went through six cycles over the past 30 years and on average, FED Funds target rates were just 0.25% below the 10 year yield when they peaked.

Even if economic conditions allow the FED to raise rates to its current target of 2.85% while maintaining its inflation goal of 2%, realized real-interest rates will most likely not exceed 1% much. All else equal, that would imply a gold price of USD1100/ozt. Hence, fundamentals would have to improve to the extent that the FED would raise rates well above its current target rates in order for gold prices to drop significantly below USD1000/ozt that some bearish commentators claim is now highly likely.

 

But how likely is that? The current federal budget deficit will be around USD540bn in 2016. Of that, USD260bn will be federal debt servicing costs. The congressional Budget office estimates that federal debt servicing costs will rise to around USD440bn by 2020 rise further to USD690bn by 2025 as cheaper debt rolls over and needs to be replaced with higher interest-bearing debt. We find the Bureau’s FED funds rate expectations of 3.5% by 2019 too high. Using the FED’s own guidance of 2.85% terminal rates implies that debt servicing costs by 2020 are likely around USD400bn per annum but will still be rising therefore as cheaper debt rolls over.

 

The estimates for the budget impact of Mr. Trump’s plans for tax cuts and infrastructure vary between USD4-6bn over 10 years. We go with the estimate of the Committee for a Responsible Federal Budget, a bipartisan non-profit organization, of USD5.3tn. In order for Federal Debt/GDP not to increase further, these policies need to generate enough economic growth to boost tax revenues as well as the denominator (GDP). A simple back of the envelope calculation using the FED’s 2% inflation target and the US census bureau’s population growth estimates reveals that even the very optimistic prognosis of 3.5-4% growth would still lead to an increase in the Federal debt/GDP level for a number of years before leveling off. In order for the FED to raise rates significantly above its current projections of 2.85% to let’s say 4%, without pushing the federal debt level much higher, real GDP growth would most likely have to be over 5%, for a full decade. This growth would have to be achieved not just as government debt servicing costs go up, but private debt costs would raise as well.

 

While there have been periods of prolonged extraordinary growth in the past, those periods were either associated with the industrial revolution or the recovery from the great depression and the US entering WWII. The chances for achieving these kinds of economic growth rates look rather dim at the moment. But that is exactly what the market seems to be pricing in now. In such a scenario, gold prices could fall below USD1,000/ozt. It would pose a major problem for producers. Most would produce at a loss and gold mining output would fall sharply. But then again, the Goldilocks scenario implies that people would want to hold less gold and more at currency. In all other scenarios, gold prices will continue their multi -decade upward trend and likely set new highs over the coming years.

 

This doesn’t mean that gold can’t trade lower over the short run from here. What the election result has really changed is business confidence. The markets’ euphoria over Trump’s election has been the match to the tinder that was the expectation for a second – and currently highly likely – rate hike by the FED in December. A mere two rates hikes in two years falls far short of the FEDs original optimistic outlook. But in the land of the blind, the one-eyed is king. Compared to the central banks of all other developed economies, the FED looks like a superstar which has boosted US rates and thus the value of the USD. This might last for a while, keeping downward pressure on gold price. But eventually it will become clear current rate path predictions are still overshooting the more probable reality.

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Submitted by Charles Hugh-Smith via OfTwoMinds blog,

Can the current iteration of global capitalism be reformed, or is it poised to be replaced by some other mode of production?

Judging by the mainstream media, the most pressing problems facing capitalism are 1) income inequality, the basis of Thomas Piketty’s bestseller Capital in the Twenty First Century, and 2) the failure of laissez-faire markets to regulate their excesses, a common critique encapsulated by Paul Craig Roberts’ recent book The Failure of Laissez Faire Capitalism.

These critiques (and many similar diagnoses) reach a widely shared conclusion: capitalism must be reformed to save it from itself.

The proposed reforms align with each analyst’s basic ideological bent. Piketty’s solution to rising wealth inequality is the ultimate in statist centralization: a global wealth tax. Roberts and others recommend reforming capitalism to embody social purpose and recognize environmental limits. Exactly how this economic reformation should be implemented is a question that sparks debates across the ideological spectrum, but the idea that capitalism can be reformed is generally accepted by left, right and libertarian alike.

Socio-economist Immanuel Wallerstein asks a larger question: can the current iteration of global capitalism be reformed, or is it poised to be replaced by some other mode of production? Wallerstein and four colleagues explored this question in Does Capitalism Have a Future? Wallerstein is known as a proponent of world systems, the notion that each dominant economic-political arrangement eventually reaches its limits and is replaced by a new globally hegemonic system. Wallerstein draws his basic definition of the current dominant system—let’s call it Global Capitalism 1.0—from his mentor, historian Fernand Braudel, who meticulously traced modern capitalism back to its developmental roots in the 15th century in an influential three-volume history, Civilization & Capitalism, 15th to 18th Centuries.

From this perspective, there is a teleological path to global capitalism’s expansion beneath the market’s ceaseless cycle of boom-and-bust. This model of ever-larger systems of global dominance has been further developed by Braudel disciples such as Giovanni Arrighi ( The Long Twentieth Century: Money, Power and the Origins of Our Times).

It is this latest and most expansive iteration of capitalism–one dominated by the mobility of global capital, state enforcement of privately owned rentier/cartel arrangements and the primacy of financial capital over industrial capital–that Wallerstein and his collaborators view as endangered.

Amidst the conventional chatter of social spending countering markets gone wild–as if the only thing restraining rampant capitalism is the state–Wallerstein clearly identifies the state's role as enforcer of private cartels. There is not just a function of regulatory capture by monied elites: if the state fails to maintain monopolistic cartels, profit margins plummet and capital is unable to maintain its spending on investment and labor. Simply put, the economy tanks as profits, investment and growth all stagnate.

This is why Wallerstein characterizes this iteration of capitalism as "a particular historical configuration of markets and state structures where private economic gain by almost any means is the paramount goal and measure of success."

Even those who reject this left-leaning description of free markets and the self-interested pursuit of profit can agree that the prime directive of capitalism is the accumulation of capital: enterprises that fail to accumulate capital lose capital and eventually go bust. As economist Joseph Schumpeter recognized, capitalism is not a steady-state system but one constantly reworked by “creative destruction,” the process of the less efficient being replaced by the more efficient.

If capital can no longer accumulate capital, this iteration of capitalism runs out of oxygen and creative destruction will usher in a new arrangement. (Wallerstein’s chapter in the book is titled why capitalists may no longer find capitalism rewarding.)

Though the status quo believes that amending the political-financial rules is all that’s needed to maintain the current centralized arrangement, Wallerstein believes that following the old rules will actually intensify the coming structural crisis. Piketty’s analysis offers a ripe example of the belief that the old rules are sufficient. To Piketty, capital’s ability to expand at faster rates than the underlying economy (as measured by GDP) has lashed the tiller on a course to rising inequality, and the only way to ameliorate the resulting social instability is to redistribute the wealth via state-mandated taxes.

Wallerstein and his collaborators see capitalism’s ability to accumulate capital as anything but fixed; in their view, capitalism is threatened by profound changes in wages and labor and the global environment. Economist Randall Collins fingers the displacement of human labor by information technology as the trigger for capitalism’s terminal crisis. Collins sees this inevitable trend as independent of economic and political theory and boom-bust cycles: “The structural crisis of technological displacement transcends cycles and financial bubbles.”

Collins acknowledges that the processes of financialization–roughly speaking, the commodification of all assets into tradable securities that are pyramided via leverage and exotic derivatives—has helped hollow out the middle class, but technology’s displacement of labor is the coup de grace that could eliminate two-thirds of the educated middle class. (His back-of-the-envelope calculation is based on the dominance of the service sector in developed economies.)

Collins rejects the commonly held optimism that new technologies always create more jobs than they destroy: “There is no intrinsic end to this process of replacing human labor with computers and other machines.”

Historical sociologist Michael Mann sees ecological crisis as the over-riding threat to global capitalism. This entirely predictable crisis has an unpredictable resolution because it derives from our era’s dominant institutions of capital, the sovereign state and consumerism all having “gone global.”

The other systemic threat is what Mann characterizes as “the treadmill of the nation-state’s obsession with growth.” The environmental degradation resulting from increasing consumption is jeopardizing the global system’s ability to stay on this GDP-focused treadmill. One need only glance at photos of choking smog in Beijing and New Delhi to grasp Mann’s point.

If the arrangement between these institutions changes radically enough, Mann envisions the possibility that the structural crisis “will stabilize into an enduringly low-growth capitalism,” a possibility with historical precedents such as 18th century Britain.

But this rosy outcome ignores the book’s key thesis that the foundations of the current system have no future because they’ve reached intrinsic limits: the returns on following the old rules are increasingly marginal. Financialization has run of out of assets to leverage into financial bubbles (what’s left to leverage–bat guano?), the middle class that has paid for its ever-expanding consumption with rising wages is in structural decline due to the displacement of human labor by software, and the state’s ability to manage structural crises while protecting global cartel profits is being undermined (in Wallerstein’s analysis) by the ever-rising costs of providing healthcare and income security and paying the external costs of environmental damage.

The old rules–inflating another credit bubble to bail out an insolvent financial sector, increasing taxes on the remaining employed, further centralizing authority and control–are no longer working; as Wallerstein observed, these are actively intensifying the structural crisis.

Wallerstein and his colleagues did not address another possible future, one that does more with less, an economic philosophy that rejects GDP as the arbiter of nation-state success and embraces the principles of the Degrowth movement (décroissance in French) that is gaining adherents in the developed world. In Japan, proponents speak of the de-Generation that is pursing Degrowth, de-materialism and de-ownership: advancement and success arise not from consuming more resources and capital, but by using fewer resources and less capital in pursuit of a more fulfilling, lower-impact lifestyle.

Piketty and Wallerstein alike overlook Nassim Taleb’s diagnosis of what’s wrong with the current state-capitalism. In Taleb’s view, wealth inequality arises not from capital’s expansion but from the state’s transfer of risk from private speculation to the public sector. As the financial crisis of 2008 illustrated, the state protects financial capital from losses and inflates asset bubbles that provide outsized returns for those with access to cheap central-bank credit.

Wealth inequality is generated not by intrinsic features of capitalism–the most important of which, in Taleb’s view, is that every participant has skin in the game, i.e. is exposed to the losses that go hand in hand with risk—but from specific state/central bank policies that reward leveraged speculation and enable financiers to play with no skin in the game.

(In Taleb’s trenchant phrase, financial inequalities are “one crash away from reallocation.”)

This suggests that one way to address both wealth inequality and speculative excesses is to rewrite the rules so that participants must have skin in the game. (Whether this is possible in an era of regulatory capture by the very financiers the rules aim to corral is an open question.)

Wallerstein and Piketty also overlook the transformative power of the factors Arrighi identifies as the key drivers of capital accumulation: attracting entrepreneurs and mobile capital.

What could replace the current iteration of global state-capitalism? If we assemble these three potentially transformative dynamics–Degrowth, the recoupling of risk and loss and entrepreneurial mobile capital–we discern a new and potentally productive teleological arc to global capitalism, one that moves from a capitalism based on hyper-centralization and obsession with rising consumption to a new capitalism focused on more efficient use of resources and capital via decentralization and localized innovation.

Rather than ask if such a “think globally, profit locally” alternative is possible, we might ponder the sobering conclusion that that current system of Global Capitalism 1.0 will be replaced with some new arrangement one way or another, and we might as well choose the more efficient, adaptive and sustainable decentralized model rather than go down with the statist-steered "the only solution is increased centralization" ship.

*  *  *

This essay was first published in The American Conservative magazine.

For what it's worth, my copy editor reckons Inequality and the Collapse of Privilege ($3.95 Kindle ebook, $8.95 print edition) is my best book. It is, if nothing else, highly relevant to today's economic/social schisms.

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Update: The market was modestly spooked as Transport Minister Delrio appeared to confirm Renzi's resignation will occur on a 'no' vote…

*  *  *

While the post-Trump euphoria in US stocks has been the perfect distraction from the ugly realities elsewhere, this weekend's Italian Referendum could well be the biggest 'revolt' yet, topping Brexit and Trump. Should Italy vote "no", as polls forecast, PM Renzi may quit, leaving the Italian bank recapitalization would then be in jeopardy and, as Bloomberg's Mark Cranfield warns "we could be looking at a Greece-like market reaction on steroids."

Italy’s referendum on Sunday is the biggest risk for markets going into year-end, according to a poll of Citigroup clients, and several risk indicators suggest investors' concern is growing…

FX hedge costs are soaring (to Brexit highs)

Italian equity protection costs are at 2-year highs relative to Europe…

And Italian government bond spread to Bunds has surged to 3 year highs…

 

So what are the Italian Referendum implications?

ABN Amro's Nick Kounis and Aline Schuling explain…

• The impact of Italy’s referendum on the outlook for its economy and wider financial markets is far from black and white
• There are a lot of possible scenarios, given the uncertainty about polls and elections, as well as the feedback loops between electoral reforms and the implications for government formation
• In case of a No vote, an interim government will likely take over and political instability and policy stagnation are likely, but the risks for euro exit in the medium term actually diminish
• A Yes vote opens up the possibility of a reformist government from 2018, but also for a euro referendum, depending on the election outcome – so it increases the tail risk on both sides
• The immediate reaction of Italian bonds will be to sell-off in a No and rally on a Yes but in both cases spreads will remain elevated
• The size of government debt, NPLs and economic stagnation mean the country remains vulnerable in either scenario

Introduction

Investor concern about European political risk has sharpened further following the surprise outcome in the US presidential elections. That result, following Brexit, is seen as confirming the surge of an anti-establishment movement fuelled by discontent at the impact of globalisation. There are a number of polls coming up, but the Italian referendum on 4 December and its potential ramifications have been in the spotlight recently. Below we tackle the key issues that arise in a Q& A format.

What is the referendum about?

The referendum is on a proposal to change the electoral system of the Senate, which has been already approved by parliament. Italy’s political system would become a single-house system, where only the lower house ratifies a government and approves most ordinary legislation. The current elected Senate would become a House of Regions and Municipalities, with limited and specific legislative powers and no right of veto. The number of MPs in the Senate would fall from 315 to 100.

The reform to the Senate is part of a broader reform to the electoral system that has been on the agenda since Matteo Renzi took office in 2014. Italy has a perfectly symmetrical parliamentary system (a bicameral system), in which the Lower House and the Senate effectively have the same powers. This tends to result in laws bouncing back from one House to the other, often blocking the legislative process and hindering policy making. A reform to the lower house (the Italicum) was already agreed by parliament but a number of appeals have been filed against it at Italy’s Constitutional Court (see box below). If both reforms of the lower house and Senate are passed, it would make government formation easier in the future and make it easier for future governments to implement their policy agenda.

 

What is the likely result?

The last opinion polls suggest that the No camp has a slight lead. Our running average of the last five polls stands at 40% for No and 37% for Yes. This essentially means that the outcome is too close to call. The gap is within the margins of statistical error. This is especially the case given the recent poor performance of opinion polls in predicting actual outcomes. In addition, there is a large proportion of the population (23%) that is undecided. The way these voters turn will have big implications for the outcome and increase the uncertainty.

What happens in case of a No vote?

There are two significant possible implications of a No. It would reduce the ability of the future governing party or coalition to pass into law its policy agenda. A future government would likely not have control of both chambers. This would make passing ambitious structural reforms more difficult. However, it is uncertain whether Mr Renzi’s Democratic party (PD), or any other party, has such an agenda anyway. On the other hand, a split in the chambers, would also make it difficult for the populist and euro-sceptic Five Star movement (M5S) to push through a referendum on the future of the euro.

The other implication would be political instability. Prime Minister Mateo Renzi has flip-flopped on whether he would stay on in his role in the case of a No vote. However, there is a significant risk he would resign. That could potentially trigger new elections in early 2017. However, we think in that case, it would be more likely that a new Prime Minister would be appointed that would lead an interim government. That government may not last its full term (early 2018) and there could be new elections in the second half of next year in any case. An alternative source of instability in case of a No is that the PD may lose support from smaller groups in the Senate, which could mean that a grand coalition (including Forza Italia) would need to make up the new government.

What happens in case of a Yes vote?

A Yes vote would mean that Prime Minister Renzi’s government would stay in place, likely through to the scheduled election in 2018. An optimistic take is that he would then be free to focus all his energies on a major structural reform programme. However, it remains to be seen whether Mr Renzi wants to pursue aggressive reforms. His track record leaves question marks. Since coming to power, his main achievement on economic policy side is labour market reform, but that was not far-reaching. In addition, the Prime Minister still needs to deal with the Senate in the current state, and he has a waver thin majority. So major reform before new elections does not seem likely. However, if he does win new elections and both the lower house and senate reforms are passed, he would be in a powerful position to implement major reforms in his next term.

There is also another scenario following the Yes vote. The forces of populism are unlikely to go away in a hurry. A new election, even in 2018, could still see the MS5 party win. It would then have (again assuming both parliamentary reforms are passed) the ability to execute its policy agenda, though it may still struggle to push through a euro referendum (see below). So a Yes win may be positive in terms of near term political stability, but could raise the risk of a more dangerous scenario in the not too distant future.

What would be the result of any new election?

A new general election is scheduled in early 2018, but as noted above could occur earlier, given the political instability a No vote could trigger. There are two complications in trying to assess the outcome of any new election. First of all we need to rely on the outcome of the current polls, which may or might not be accurate, and in any case may change up to the election. The second is that outcome will also depend on to whether the electoral system will change (fully or partially).

The latest polls suggest that PD would still be the biggest party. PD is currently polling at 33%, while MS5 is at 28%. Still given the uncertainty of the polls and the potential for swings, MS5 still has a realistic chance of winning. If the electoral reform of the Lower House is passed before the new election, then PD or MS5 would emerge as the dominant force in the lower house as the system ensures that winning party has more than 50% of the vote. If the senate reform has also passed (so in case of a Yes vote in the referendum) the winning party in the lower house would have significant power to pass through its legislative agenda. However, if the reform does not pass, dominance in the Lower House may not amount to much, as the Senate would remain able to frustrate the government.

If the electoral reform of the lower house is blocked by the Constitutional court (or if it is significantly watered down) Italy may well find it very difficult to form a new government. This is because the electoral law under which Renzi’s government was elected, which also had a winner premium to help ensure a majority, was ruled unconstitutional by the Constitutional Court in 2014. If this law is not replaced by the Italicum, any new election would be decided by full proportional representation. This means that the winning party would have to form a coalition given current polling. The next biggest party in the polls is Lego Nord (12.1%) followed by Forza Italia (11.5%). Assuming that PD and MS5 would not want to form a coalition, the other combinations look problematic, and would in any case need to involve a multitude of small parties. In this case, a ‘Spain scenario’ where coalition negotiations are drawn out and new elections become necessary would seem likely.

What is Five Star’s policy on Europe?

The Five Star movement is against Italy’s membership of the euro, but not necessarily of its membership of the EU. Last month, Luigi Di Maio, a MS5 party leader in the lower house of parliament who is often seen as a possible future prime minister, set out the party’s position on the euro in a recent interview. He said he would like to ‘see a European referendum on the euro, to see other countries starting to talk about it’. He added that it would be ‘a consultative referendum’. He also noted that Italy should explore other alternatives to the euro and mentioned a return to the lira, as well as the (more fanciful) idea of splitting the eurozone into different currency areas.

Would a No vote start the countdown for Italy’s euro exit?

We do not think that a No vote would increase the chances of an Italian euro exit. It actually might make it less likely. The nightmare scenario for financial markets in simple terms is that a No triggers early elections, MS5 wins, it holds an in-out euro referendum, which leads to a vote for ITEXIT. However, in case of a No vote, the situation would be more complex. As described above, without parliamentary reform, MS5 would struggle to form a government and to pass the legislation to hold the referendum.

In many ways a YES vote followed by a MS5 win in 2018 could actually be the scenario which implies the bigger risk of ITEXIT. This is because MS5 would have more legislative power. However, even then there would be significant hurdles to overcome. The constitution does not allow referenda on pulling out of international treaties, though it does allow advisory referenda. However, to launch an advisory referendum, there needs to be a two-thirds support in parliament currently (though this could change eventually). Even assuming the Italicum reform sticks and MS5 wins the election, they would still struggle to achieve that. MS5 would then have 340 seats. Given current polling, the other Eurosceptic party Lega Nord would have around 55 seats. So it would need to increase its share of the vote significantly (from the current 12.5% to around 16.5%) to push the combined MS5-Lega Nord to the two-thirds majority necessary. If it does not get that majority, it would need to a referendum to hold the advisory referendum.

If it MS5 were to manage to hold a consultative referendum, then the public would need to vote to leave the euro. Most polls suggest a majority of the Italian public favour staying in, though support has diminished and the gap is now small. If the public did vote to leave, the government could then use that referendum as a mandate to start the process of a euro exit.

What is the most likely scenario?

There are a lot of possible scenarios, given the uncertainty about polls and elections, as well as the feedback loops between electoral reforms and the implications for government formation and policymaking. We have set out a scenario tree in Figure 3. Based on opinion polls, and the anti-establishment trends more generally, we judge that a No outcome (55%) is more likely than Yes (45%). The Italicum law would also most likely be watered down in such a scenario, meaning that future government formation as well as policymaking would be difficult. A Yes outcome would make less likely that the Italicum is watered down, given that Mr Renzi is a stronger supporter of it. However, other reforms before the next election (early 2018) would probably not be likely given that the current situation in terms of parliament would remain in place until then and Mr Renzi would not likely take measures that could hit his popularity in the run up to the poll.

A strong government beyond the next election would be very likely following a Yes vote. Given current opinion polls a strong PD government would be the more likely and it would then have the possibility to be a reformist government that tackled Italy’s economic problems. However, that is not a given, as that also would depend on the willingness of that government to follow an aggressive reform path, which could still lead to strong opposition from trade unions and other vested interests. Alternatively, an MS5 government could win the elections and take power. However, it would be a small probability within that scenario that they could enough support in parliament to hold a referendum on the euro, given the higher hurdle to pass constitutional laws.

How severe are Italy’s economic problems?

Italy badly needs an economic reform programme to boost its potential growth rate. Its potential growth is generally estimated at close to zero due to ageing and weak productivity growth (see Figure 4). Surveys of international competitiveness suggest it is structurally one of the weakest economy’s in the eurozone, with only Portugal and Greece ranked more poorly (Figure 5). The low potential growth rate exacerbates the country’s two other economic problems: its mountains of government debt and non-performing loans.

We have made some debt projections set out in the chart below. In the base case, we assume that nominal growth averages 2.5% in coming years, that the primary surplus gradually rises from 1.5% now to 2.5% and interest payments roughly trend at current levels. That leaves the debt ratio trending down only slightly to around 130% GDP in 2025 from 133% now. Furthermore, Italy’s debt sustainability could come into question in the case of even relatively moderate shocks. For instance, assuming 1% slower nominal growth and 1% higher interest rate, would see the debt ratio rising to 160% GDP over that horizon. Arguably the nominal GDP growth we assume is rather ‘generous’ given current potential growth estimates and trends in inflation.

At the same time, Italy’s banking sector needs more capital given the high level of non-provisioned loans. We estimate that if the banking sector sells its NPLs at 25-35%, given the current provisioning, this would imply a capital short-fall of EUR 88-124bn. This amounts to 5.5-7.8% GDP. This would significantly increase the government debt ratio if there was a direct re-capitalisation following a bail-in. Up until now, the government has been trying to find private sector solutions to re-capitalise its banks, but there are serious question marks about investor appetite.

What are the market implications?

The immediate reaction of Italian government bonds will be to sell-off in a No and rally on a Yes but in both cases spreads will remain elevated. The 10y spread over Italy could move towards 200bp in the first instance in the case of a No, and back towards 140bp in case of a Yes vote. However, these early moves would probably to some extent unwind (especially in case of the initial reaction following a Yes). It would likely become clear that a No vote would not immediately open the door for a MS5  government, while a Yes vote would not lead to much reform in the next year, while it could eventually put MS5 in the driving seat after the next elections. Crucially, we think the key issue is Italy’s economic vulnrabilities, which will remain in place over the next year whatever the result of the poll.

The ECB’s ongoing QE policy should limit the upside for Italy’s government bond yields. Given current sovereign credit ratings, Italy has a quite a buffer before all four agencies place its debt in the sub-investment grade category that would make its bonds ineligible for ECB asset purchases. The ECB bases itself on the highest rating, which currently is given by Fitch, which is three notches away from sub-investment grade (though with a negative outlook).

Reuters reported that the ECB is ready to temporarily step up purchases of Italian government bonds if the outcome of the referendum on Sunday leads to a surge in the country’s bond yields. It cites four unidentified ECB officials who also noted that the move would not necessarily need Governing Council approval. The ECB already deviates from the capital key to make substitute purchases to make up for not being able to make targets for countries where holdings have reached the issuer limit or for other technical reasons. However, this would be a relatively modest and temporary phenomenon because it cannot sharply and persistently deviate from the capital key under the current rules of the programme. Indeed, the Reuters report quotes the officials saying such a policy would be limited to ‘days or weeks to counter any immediate volatility’. If Italy needed long-term support, it would need to officially ask for help according to the report. This would presumably be via the OMT, though that would require Italy entering a reform programme, which would be politically very challenging.

However, an economic shock that leads to a sharp deterioration in the outlook for growth and government debt could increase concerns that there would be significant downgrades in the future. Alternatively, in the scenario where MS5 did get into government following parliamentary reform and did manage to hold a euro referendum, this would also obviously be a major game changer that would see Italy’s spread over Germany explode. An additional element, is that if investors do become worried, a surge in yields would also lead to a sharp deterioration in the government debt outlook, so could become a self-fulfilling prophesy.

On the positive side, following the next elections, a reformist PD government in a reformed parliament, could lead to a rise in growth expectations, leading to a virtuous circle of lower spreads and an improving debt outlook.

*  *  *

So that's the long version, but we leave it to Doug Casey to sum it all up succinctly:

Italy would be the first domino to fall.

 

December 4 referendum fails >> M5S comes to power >> Italians vote to leave the euro currency >> European Union collapses

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From the 316 rig trough in May, American oil drillers have added 161 to 477 – the highest since January 2016. The rising rig count continues to track lagged oil prices higher and US crude production is following that trend to its highest level since June.

US Oil Rig count is up 3 in the last week to 477 – up 25 of the last 27 weeks…

 

And with the OPEC deal holding oil prices, is US production set to rise no matter what?

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Shortly after Donald Trump picked former Goldman partner Steven Mnuchin as Treasury Secretary, he was rumored to be considering another Goldmanite, current President and COO Gary Cohn – who as reported earlier this week is already contemplating “life after Goldman” – for energy secretary. The follows a previous report that Trump may appoint Cohn as head of the Office of Management and Budget. So, as Trump wonders which other Goldman banker to poach to fully outsource financial management of the US directly to Goldman, a taxpayer-backed hedge fund which has already taken over the world’s central banks, he decided to spread the Wall Street love and earlier today announced that he has created an economic panel chaired by Blackstone’s Stephen Schwarzmann, whose members will also include such illustrious “non-swampies” as Jamie Dimon and Larry Fink, as well as various other “prominent U.S. business leaders” to get Wall Street’s advice on such matters as … job creation. 

The President’s Strategic and Policy Forum will begin meeting with Trump in February after his inauguration. From the announcement:

President-elect Donald J. Trump today announced that he is establishing the President’s Strategic and Policy Forum. The Forum, which is composed of some of America’s most highly respected and successful business leaders, will be called upon to meet with the President frequently to share their specific experience and knowledge as the President implements his plan to bring back jobs and Make America Great Again. The Forum will be chaired by Stephen A. Schwarzman, Chairman, CEO, and Co-Founder of Blackstone.

 

Members of the Forum will be charged with providing their individual views to the President – informed by their unique vantage points in the private sector – on how government policy impacts economic growth, job creation, and productivity. The Forum is designed to provide direct input to the President from many of the best and brightest in the business world in a frank, non-bureaucratic, and non-partisan manner.

This is the same Schwarzman who during the Republican primaries in October 2015, characterized Trump as “the P.T. Barnum of America.”

Other members include General Motors Co. chairman and CEO Mary Barra, Cleveland Clinic CEO Toby Cosgrove, Bob Iger of the Walt Disney, Wal-Mart Stores Inc. president and CEO Doug McMillon, and former Boeing Co. chairman James McNerney, as well as the above named Jamie Dimon of JPMorgan Chase and BlackRock Inc.’s Larry Fink,

“This forum brings together CEOs and business leaders who know what it takes to create jobs and drive economic growth,” Trump said in a statement issued by Blackstone. “My administration is committed to drawing on private sector expertise and cutting the government red tape that is holding back our businesses from hiring, innovating, and expanding right here in America.”

Sadly, it was the private sector’s policies, expertise and “advice” to the Obama administration, that led to this particular outcome: 

It also led to record stock buybacks and all time high stock prices, not to mention record CEO compensation, but surely Trump will see right any such attempts to pass “advice” meant to help the people whose only intention is to make a handful of Wall Street oligarchs even richer… right.

Schwarzman, the 69-year-old private equity executive who will chair the forum, said at the Wall Street Journal CEO Council after the election that he is “excited” about the prospects for economic growth in America and expects the business horizon to look “infinitely better” in the next few years.

“Things are going to change, and I think things are going to change a lot,” he said. He did not refer to Trump by name.

In an interview with Bloomberg before the election, Schwarzman said he was undecided between Trump and Clinton. He said the GOP nominee’s plans for economic growth sound “wonderful if you could do that,” but also expressed concerns about his immigration plans.

“If you were really removing a large number of people, that’s got to adversely affect the economy,” he said.

Other panel members are also prominent Clinton fans: Disney’s Iger, 65, supported Hillary Clinton during the campaign and co-hosted a fundraiser for her over the summer. However, he too quickly changed his tune in the days following Trump’s election, when he said he was “hopeful” about what’s to come in an interview with CNBC.

“There is going to be far more energy around attacking the tax code, changing the tax code, closing loopholes on corporate taxes and lowering the base,” he said. “We’re not as competitive as we need to be as a country. I think that is going to be addressed on a timely, meaning a fast basis. That’s certainly good.”

Jim McNerney, former chairman and CEO of Boeing, who is also on the committee, once referred to Trump’s rhetoric on trade as “dangerous.”

The full list of panel members include the following:

• Stephen A. Schwarzman, Chairman, CEO, and Co-Founder of Blackstone
• Paul Atkins, CEO, Patomak Global Partners, LLC, Former Commissioner of the Securities and Exchange Commission
• Mary Barra, Chairman and CEO, General Motors
• Toby Cosgrove, CEO, Cleveland Clinic
• Jamie Dimon, Chairman and CEO, JPMorgan Chase & Co
• Larry Fink, Chairman and CEO, BlackRock
• Bob Iger, Chairman and CEO, The Walt Disney Company
• Rich Lesser, President and CEO, Boston Consulting Group
• Doug McMillon, President and CEO, Wal-Mart Stores, Inc.
• Jim McNerney, Former Chairman, President, and CEO, Boeing
• Adebayo “Bayo” Ogunlesi, Chairman and Managing Partner, Global Infrastructure Partners
• Ginni Rometty, Chairman, President, and CEO, IBM
• Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics, Hoover Institute, Former Member of the Board of Governors of the Federal Reserve System
• Mark Weinberger, Global Chairman and CEO, EY
• Jack Welch, Former Chairman and CEO, General Electric
• Daniel Yergin, Pulitzer Prize-winner, Vice Chairman of IHS Markit

For some inexplicable reason, Warren Buffett failed to make the list, if only for the time being.

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