For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
(popular proverb illustrating chaos theory)
Italy Emerges from Quietude
We have mentioned the risks Italy poses to the euro area in the past, but the markets proceeded to ignore both Italy and Spain for quite some time, by compartmentalizing them into the 'not as risky as the GIP trio' drawer (GIP=Greece, Ireland and Portugal). There was thus little reason to dwell on it too much, but it was always clear to us that the topic would eventually make a comeback. As we have frequently mentioned, it has always been our belief that contagion would rear its ugly head again at some point.
In early July 2010 we posted 'Faith In The Impossible', where we inter alia discussed the situation of Italy in a paragraph with the title 'Italy is quietly lying in wait'. It appears it is no longer so quiet.
In late May this year we posted 'Et Tu, Italy?', following an announcement by the rating agencies that Italy's credit outlook was to be moved from 'stable' to 'negative'. The main worry with regards to a possible downgrade of Italy's government debt relates of course – as always – to the banking system. Italy sports the second highest public debt-to-GDP ratio in the euro area at 120% and the exposure of the euro area banking system (chart) – and especially the Italian banks themselves – to the €1.2 trillion large Italian government debt mountain is commensurately staggering.
The markets have hitherto treated Italy's public debt situation as 'slightly dubious, but not outright alarming'. As we have noted before, there has been a perception that due to Italy's high personal savings rate and the large proportion of Italian government debt held domestically, Italy could be seen as a kind of European version of Japan, able to amass a large amount of government debt without having to fear ill effects. It seems now that the markets are in the process of reassessing this particular notion. Both CDS prices and the yields on Italian government bonds have recently sprinted higher, with the latter only a smidgen away from breaking out to new highs for the move.
Italy's 10 year government bond yield ends the week at 4.977%, perilously close to breaking out from the sideways consolidation that has pertained for most of this year. Spain's government bond yields have just broken out from a similar consolidation formation – click for higher resolution.
What is undeniable is that Italy's stock market has been mired in a bear trend for quite some time. The Milan stock exchange index (FTSE-MIB) has made its post 2008 crash rebound peak in October of 2009 and has gently drifted sideways/lower ever since.
The Milan Stock Exchange Index (MIB) has been a 'bear market leader' since 2007. It peaked in May of 2007 – well ahead of the S&P 500 Index. It made its post crash rebound high back in October of 2009 – click for higher resolution.
The MIB has been in a relentless downtrend relative to the S&P 500 – click for higher resolution.
The MIB has also just plummeted to a new low vs. gold – click for higher resolution.
Last Friday, the Italian stock exchange sported a solid gain of just over 307 points two hours into the trading day. European markets took their lead from a strong day in Asian stock markets following remarks by China's premier Wen Jiabao that 'China is winning the war on inflation', which market participants evidently took as a hint that the recent tightening of monetary policy in China may be close to ending. An unexpected small gain in the German business confidence index (IFO index) reported early on Friday also boosted sentiment at the beginning of the trading session somewhat.
It looked as though a 'risk-on' day was in the works, which means 'sell the dollar, and buy the euro, stocks and commodities'. Alas, it was not to be. At about 11:00 a.m. Central European time, a rumor surfaced that Italian banks would have to raise more equity in the wake of the most recent European 'stress test' exercise and that a major credit rating agency was preparing to downgrade Italy's sovereign debt. Late on Thursday, Moody's had warned that 16 Italian banks faced a possible credit rating downgrade in the event of a downgrade of Italy's sovereign debt, coupled with 'a reassessment of the willingness of governments to support the debt of financial companies'. This was initially ignored, but when the above mentioned rumors started on Friday morning, the remarks by Moody's no doubt lent additional credence to them. Italian bank stocks literally crashed within minutes – with many falling by the 10% daily threshold after which trading halts are imposed by the Milan exchange. The weakness in Italian bank stocks then quickly spread across Europe, with UK banks especially hard hit, not least because BoE chairman Marvyn King muttered darkly about the risks the euro area debt crisis poses to financial stability in the UK – echoing Jean-Claude Trichet's 'red alert' remarks made on Wednesday in connection with the euro area's banking system.
“A gauge of banks was the worst performing industry in the Stoxx 600 this week, sliding 4.3 percent to the lowest level since July 2009.Popolare Milano, the oldest Italian cooperative bank, plunged 15 percent to the lowest since at least 1989. Monte Paschi slid 11 percent, the biggest drop in more than a year.
Moody’s Investors Service said on June 23 that it may downgrade 13 Italian banks because they would be vulnerable were the government’s credit rating to be cut. The ratings company last week warned that Italy’s credit ratings may be trimmed because of slowing economic growth and the potential for the sovereign crisis to drive the country’s borrowing costs higher.
European Central Bank President Jean-Claude Trichet on June 22 said danger signals for financial stability in the euro area are flashing red as the debt crisis threatens to infect banks.
Lloyds Banking Group Plc, Britain’s biggest mortgage lender, fell 10 percent and Royal Bank of Scotland Group Plc decreased 12 percent.
The euro-area debt crisis poses the biggest risk to the stability of the U.K. financial system and banks should build up capital buffers when earnings are strong, Bank of England Governor Mervyn King said in London yesterday.
(our emphasis)
