G7 Summit shows leaders are forgetting the lesson of the 1930s

G7 May17G7 Summits began in the crisis years of the mid-1970s, bringing Western leaders together to tackle the big issues of the day – oil price crises, the Cold War with the Soviet Union and many others.  Then, as stability returned in the 1980s with the BabyBoomer-led economic SuperCycle, they became forward-looking.  The agenda moved to boosting trade and globalisation, supporting the rise of China and India, and the IT revolution.

This weekend’s 43rd Summit in Italy suggested we may be going back to earlier days.  As the picture confirms, the leaders did all meet in the Italian city of Taormina in Sicily.  But they clearly found it difficult to meet the challenge set by their hosts of “Building the Foundations of Renewed Trust”.  One very worrying sign was that both the USA and the UK seem to have become semi-detached from the process. :

□  UK premier Theresa May left early, to “hold urgent talks with her election campaign chiefs” after new polls showed her lead dropping to single figure levels
□  President Trump refused to endorse the Paris Agreement, causing German Chancellor, Angela Merkel, to comment:
“The entire discussion about climate was very difficult, if not to say very dissatisfying. There are no indications whether the United States will stay in the Paris Agreement or not.”

There was some good news, with a compromise seemingly being agreed with US President Trump over his desire to dismantle the world’s open trading system, as the final statement noted:

“We reiterate our commitment to keep our markets open and to fight protectionism, while standing firm against all unfair trade practices. At the same time, we acknowledge trade has not always worked to the benefit of everyone.”

But it was a relatively weak statement, and nothing was said about the President’s withdrawal from the Trans-Pacific Partnership, or his decision to demand a formal review of the North American Free Trade Agreement. The change is even clearer by contrast with last year’s Summit in Japan, when the leaders committed:

To fight all forms of protectionism ….(and) encourage trade liberalization efforts through regional trade agreements including the Trans-Pacific Partnership, the Japan-EU Economic Partnership Agreement, the Transatlantic Trade and Investment Partnership and the Comprehensive Economic and Trade Agreement.”

Sadly, the same lack of unity had been seen just before the Summit, when President Trump failed to endorse Article 5 (the fundamental principle of the NATO Alliance), which declares that an attack on one member state is an attack on all, and requires a mutual response.  As the Financial Times noted:

This was particularly galling given that he was attending a memorial for the September 11 terror attacks — the only time Article 5 has been triggered. It remains unclear why he equivocated.”

Even the Summit dinner saw a lack of unity, with US National Economic Council director Gary Cohn suggesting:

There was a lot of what I would call pushing and prodding.”

This lack of a common purpose amongst Western leaders is deeply worrying.  Of course, they were able to agree on strong words about terrorism and the role of social media.  But their key role is to be pro-active, not reactive.

Collectively, their countries are responsible for nearly two-thirds of the global economy.  Individually, none of them – not even the USA – can hope to successfully tackle today’s challenges.  This was the rationale for the formation of the G7 in 1975, and it has since played a critical role in helping to spread peace and prosperity around the world.

Today’s G7 leaders seem to be in danger of forgetting their core purpose.  They need to re-open their history books and focus on the lesson of the 1930′s, when “beggar-my neighbour” trade policies led directly to World War II.

 

Italy’s referendum is next test for Eurozone stability

ItalyItaly was one of the 6 founding members of the European Union (EU) in 1957, along with France, the Netherlands, W Germany, Belgium and Luxembourg.  Its referendum next month will therefore be a critical test of whether the Eurozone and EU can survive the pressure from the Populists.

If the Populists win, then the future of the Eurozone and the EU itself will be in doubt.

As often happens at critical moments, the subject of the referendum is of relatively minor importance.  It was called by Premier Matteo Renzi to amend the constitution by approving a reform of Italy’s Parliament.  The problem is that he then made himself the key issue in the referendum, by promising to resign if he lost, as he confirmed to Italian media last week:

If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government”

Italy is now in a 2 week blackout period for polling before the vote on 4 December.  But the final polls showed the “No vote” with a comfortable lead.  There is therefore a major risk that Renzi will soon be following UK premier Cameron out of office.  3 quite different Scenarios could then develop:

Another premier takes over.  Italian premiers have historically not lasted long.  Before Renzi took over in 2014, there had been over 50 different premierships since Italy’s first post-War premier, Alcide de Gasperi, resigned in 1954. So maybe, the revolving door revolves again, and a new premier is appointed by the President
New elections are held, and another premier takes over.  Renzi was the 3rd Italian premier in a row to take office without have a personal mandate from an election (neither Mario Monti or Enrico Lette had this).  An election may therefore take place, after which perhaps the revolving door revolves again
New elections are held and an anti-euro coalition takes office.  This would seem to be the base case Scenario, with a probability of at least 50%.  It would likely means that Beppe Grillo’s anti-euro 5 Star Movement would take office with Berlusconi’s Forza Italia and the Northern League, and would then hold a referendum on leaving the euro – with the aim of capping Italian debts and nationalising its banks, as Grillo has promised

Given that around €360bn ($400bn) of all Italian loans are classed as “troubled”, and amount to around one-fifth of total loans, capping the debts would cause major disruption to the Eurozone and global financial systems.  Leaving the euro would also mean, that foreign holders of Italian debt would be paid in Italian lira, not euros.  And presumably this would be after a devaluation of the lira.  So as the Financial Times warned on Monday:

“Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.”

DEMOGRAPHIC REALITY IS NOW CONFRONTING STIMULUS FANTASY
Italy’s real problem is not its Parliament, but that its economic policies haven’t adjusted to the New Normal world. Like most developed countries, politicians of all parties have failed since the end of the BabyBoomer-led SuperCycle, to understand the trade-off that has taken place between increased life expectancy and economic growth.  Italy has a median age of 45 years, and as the chart above shows:

 It now has only 24m in the Wealth Creating 25 – 54 cohort, versus 22m New Olders in the 55+ cohort
 By 2030, it will have just 20m Wealth Creators and 26m New Olders
 This is completely different from the 1950 position, when there were 18m Wealth Creators and only 8m New Olders

In addition, of course, Italy has become the main route for migrants and refugees following the EU’s deal with Turkey. 168k people have already arrived this year, compared to 154k in the whole of 2015 and 170k in 2014. Resources have been further strained by the sequence of earthquakes, which are made worse by the lack of anti-seismic regulations for its buildings.

It is small wonder, therefore, that the 5 Star Movement is building support, having won Rome in this year’s elections, whilst the Lega Nord (Northern League) won the Veneto and Lombardy regions.

Nor is it surprising that investors are starting to panic.  As I discussed on Monday, Italy’s 10 year interest rate has doubled to 2% since the summer.  It could go very much higher if Renzi loses, as the prospect of a vote to leave the eurozone and cap Italy’s debts comes closer.

This is the Great Reckoning in action, and there is probably little that the European Central Bank (ECB) can do to mitigate the position.  In a few weeks’ time, investors may well wonder how they allowed Italian interest rates to trade below US rates for much of the past few years.  And in a few months’ time, it may well seem equally incredible that anyone ever believed ECB’s President Mario Draghi’s 2012 boast that:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. 

It could be a very difficult H1 in 2017.  Next month’s Italian referendum is followed in March by Dutch elections and in May by France’s Presidential election.  Both may well be won by parties committed to leaving the EU itself.

It is therefore hard to ignore the possibility that by June, the EU could have effectively ceased to exist in its current form.  Developing a contingency plan, in case this develops, could well be the wisest move you make in 2016.

“Disaster is still some way off” for Cyprus, as Germany prepares to vote

Cyprus Sept13Back in April, the blog suggested that capital controls might remain for rather longer in Cyprus than the “few days or weeks” suggested by the central bank.  And a month later, the bank was still unrealistically claiming they would be lifted “as soon as possible”.

Today, the blog’s own view that they could be in place “for a decade or more” is looking more and more likely.

As the chart from the Wall Street Journal shows, the decline in GDP is accelerating, contrary to all the official forecasts.  GDP fell 4.8% in Q1 and 5.4% in Q2.  As the Journal notes:

“Christopher Pissarides, a Nobel laureate and head of the government’s council of economic advisers, acknowledges that the economy is sinking faster than expected.”

Credit has basically stopped on the island, with most transactions now in cash.  And the economy’s downward spiral is likely to intensify.  Unemployment was 17.3% in June, well above the forecast of 15.5%.

Basic industries are suffering badly.  Cement sales are only 25% of those in 2008.  And as Mr Pissarides added in an unguarded moment ”disaster is still some way off. But times are getting tougher.”

Clearly this is very bad news for Cypriots.  But it is equally ominous for the Eurozone for 3 key reasons:

  • Cyprus is in the Eurozone.  Its use of capital controls means they could happen in other member countries
  • Its bailout was the first one where depositors suffered major losses, also setting a precedent for the future
  • The policy prescription has now had 6 months to work, and has clearly failed

This would not matter if the rest of the Eurozone was healthy.  But it isn’t.  Germany’s finance minister has said Greece may another bailout of perhaps €10bn.

Click here to view the embedded video.

And then there is Portugal, whose economy is also getting worse, not better, as this Financial Times video shows.

So what will happen with Greece and Portugal?  Will the German taxpayer be asked to pay the bill all on their own?  Or will investors instead be forced to take another ‘haircut’ – to use the phrase popularised with Cyprus?

Neither option looks good.  As the blog noted in its 4 Butterflies post last month, we all know that these issues cannot be discussed before the German election on 22 September, for fear of frightening voters.  Markets clearly expect Germany to then pick up the bill on 23 September.   But the blog is not so sure.

Investors are complacent today, but they are not stupid.  If Germany forces them to take a haircut or suffer capital controls in Portugal or Greece, they will immediately worry about what might happen next in Spain and Italy?  Both will likely need outside help before too long.  Spain is not a small island like Cyprus, but the 13th largest economy in the world.  And Italy is not a minor country like Greece, but the world’s 9th largest economy.  Combined, their economies are the same size as Germany’s.

Most large companies have some exposure to both Spain and Italy either directly or indirectly.  Any CFO who hasn’t already developed a contingency plan for the period after 22 September, clearly has a few sleepless nights ahead.

Italy’s oil consumption back at 1967 levels

G20 Dec12.pngThe wrong diagnosis can often make the problem worse not better, as doctors know very well. But the message hasn’t got across to policy makers. They refuse to believe that ageing populations spend less and save more – even though all the evidence confirms this commonsense observation. So instead, they have convinced themselves the world is facing a repeat of the 1930’s Depression.

The tragedy, as future historians may well conclude, is that their wrong diagnosis risks causing the very disaster they are trying to avoid. A first sign of this comes from Italy, currently the world’s 8th largest economy with GDP of $2.2tn. Italian paper Il Sole reports that 2012 oil consumption has dropped 11.4% in one year. It is now back at 1967 levels.

The chart above looks at the G-20 nations, who comprise 79% of the global economy:

• The Y axis shows GDP/capita in US$
• The X axis shows median age for each country
• The blue ‘bubbles’ are the size of each country’s economy versus the USA

As it shows, the countries fall into 3 distinct groups:

Rich but Old. These wealthy countries have median ages mostly over 40 years
Poor but Young. These relatively poorer countries have median ages around 25 years
Poor but Ageing. China and Russia are in their own group: China because it has lost 400m babies due to the one child policy; Russia because of its high cigarette and alcohol consumption

Today’s mix of austerity and stimulus policies ignores these basic demographic facts. Italy’s plight is thus the most obvious example of the failure of policy makers to tackle the real issues.

EU banks cut lending to the PIIGS by 23% of GDP

BIS loans May12.pngOn 7 September 2008, in its now famous warning that a financial crisis was imminent, the blog noted that “‘Deleveraging’ is an ugly word, and it has ugly implications“.

The chart above shows just how ugly these implications are becoming for the PIIGS countries (Portugal, Italy, Ireland, Greece, Spain).

It is based on data produced since 2009 by the Bank for International Settlements (the central bankers’ bank), and shows the major EU lending flows to the PIIGS. It includes data just published for December 2011:

• Lending to Italy (a G7 group member) has fallen 37%
• Lending to Spain (the world’s 12th largest economy) has fallen 40%*
• Lending to Greece (now in default) is down 54%
• Lending to Portugal is down 32%, and to Ireland down 41%

Major countries simply cannot continue to operate ‘as normal’ when these vast sums of money are being withdrawn from their banking systems:

• Italy has lost $352bn, equal to 32% of its GDP
• Spain has lost $$313bn, 21% of GDP
• Greece has lost $99bn, 33% of GDP
• Portugal has lost $75bn, 32%: Ireland has lost $203bn, 93%

Overall, $1.04tn has been withdrawn, a 39% reduction since December 2009. This is equal to 23% of the PIIGS’ combined GDP.

These numbers, of course, explain why the European Central Bank (ECB) made its emergency €1tn ($1.4tn) loans at the end of December. It says it was seriously concerned “a dangerous loop involving low economic activity, funding stress for banks and a reduction in lending” might occur. This is central bank-speak for saying that the European banking system might well have collapsed.

But the ECB’s lending under the Long Term Refinancing Obligation was just that, lending. It dealt with the immediate cash-flow problem in December. But it did not deal with the solvency issue. Many of these loans will never be repaid, as the assets behind them are now worthless.

* Netherlands lending to Spain is estimated in line with June 2011 levels, as the data is not yet available

Fragments from the G20

G-20.jpg3 years ago, many hoped the G20 group of the world’s wealthiest countries might work together to solve the global financial crisis.

Last week’s Cannes meeting ended that illusion.

Instead, its decision to abandon the Doha trade round, launched in 2001, made it clear we have passed the high-water mark of globalisation. This conclusion was reinforced by the fact that only a few of the news media even mentioned the topic.

Two key figures also set out their views on the way forward:

China’s premier Wen, signalled that its lending slowdown will continue: “I will especially stress that there will not be the slightest wavering in China’s property-tightening measures–our target is for prices to return to reasonable levels.” Prices have already begun to fall by 20-40% in the major cities, and clearly more falls are on the way.

Italy’s premier Berlusconi was still in denial, however, claiming the country’s problems with its debt mountain were “a passing fashion“, and noting that “the restaurants are full, the planes are fully booked, and the hotel resorts are fully booked as well“.

And that, as far as the blog can discover, was that.