It was an eventful week. Italy’s president vetoed the proposed finance minister put forward by M5S and the Northern League potentially leading to fresh elections. Italian bonds and equities promptly sold off sharply. Alternatives have been considered and it now appears a compromise solution has been reached with the prime minister designate presenting an amended list of cabinet ministers. Elsewhere, Spanish premier Marian Rajoy was ousted in a vote of no confidence.
The political turmoil in Europe hit banks particularly hard as the yield on peripheral sovereign bonds surged. The volatility even spread to US banks where this week, the Volcker rule and Dodd Frank were being pruned back to give banks more latitude to operate.
The Italian situation is problematic. The Northern League would cut taxes while M5S would pay a universal basic income. Neither has a plan to finance this largesse and Italy’s growth rate is too low and national debt too high (at over 130% of GDP) for the government to budget this way. Fortunately, most of the debt is held internally and Italy, at least for the moment, maintains a primary budget surplus (of 1.7%). However, the situation does complicate the job of the ECB. If it terminates QE, peripheral spreads will widen, yet it can hardly extend QE simply to fund intransigent member states’ nonviable fiscal plans. As for the risk of Italy exiting the currency union, this risks is yet low. While Italy would like to breach the Maastricht budget conditions it certainly doesn’t want to abandon the euro since this would mean much higher funding costs and an acute and instantaneous loss of purchasing power.
On the international trade front, the Trump administration’s protectionist agenda rolled on. The US has begun an investigation into whether car imports are threat to US national security, threatening the European and Japanese car industries. At the same time, as tariffs on Chinese imports were put on hold, new directives to tax 50 billion USD of Chinese imports were announced. The arbitrary and unruly evolution of US trade policy is increasingly destabilizing to global trade, and encourages a hawkish response from trading partners, allies and competitors alike. The invocation of technicalities such as Section 232 of the Trade Expansion Act will be seen as an act of bad faith leading to openly hostile strategies. In a low growth environment, the reality is that a trade war is the most likely outcome and one that will become the norm. The question is with what intensity and strategies will this war be fought, will it be a cold or hot war.
Turning to economics, the US economy is recovering for a soft patch. Non-farm payrolls rose 223k in May, above expectations. The unemployment rate fell to circa 3.7%. Average hourly earnings rose 0.3% exceeding expectations and driving the year-over-year rate up to +2.7%. Look beyond the politics and the US economy continues to look in fine shape.