Renzi Falls, Markets Rise

Doug Nolan

Italian bank stocks (FTSE Italia bank index) declined a modest 2.3% Monday on the back of Sunday’s resounding defeat of Italian Prime Minister Renzi’s political reform referendum. The bank index then proceeded to surge 9.0% Tuesday, 4.5% Wednesday and another 3.6% Thursday, for a stunning 27% rally off November 28th trading lows. As they say, “par for the course.” Italian 10-year sovereign yields rose eight bps Monday, yet by Wednesday’s close yields were actually lower on the week. Italian sovereign CDS ended the week little changed. Italian stocks gained 7%.

Following Brexit, Trump’s win and Renzi’s defeat, hedging market risk has been relegated to the status “senseless lost cause”. A short squeeze and unwind of hedges fueled this week’s 12.7% Italian bank rally, along with a 9.5% surge in European banks that reverberated in Asia (Japan banks up 5.6%), the U.S. (banks up 5.4%) and globally. Especially in Europe, a reversal of bearish hedges created powerful buying power. It’s a common trading strategy to purchase put options with proceeds from selling out-of-money call options. Increasingly in the U.S. and in Europe, equities trade as if those on the wrong side of derivative (calls) trades are being forced to hedge exposure by aggressively purchasing stocks into a rapidly rising market. It’s a self-reinforcing market dislocation similar to that which not many months back fueled a historic collapse in global bond yields.

One is left to assume that there must be some silver lining to Renzi’s defeat and resignation. 
From a fundamental perspective, it’s not obvious where to look. Italy’s anti-establishment Five Star Movement and Northern League political parties are salivating at the thought of new elections possibly early in the year (some speculating February). The Continent’s anti-euro and anti-establishment parties are emboldened. Meanwhile, the slow-motion Italian banking train wreck is chugging along.

December 9 – Reuters (Silvia Aloisi and Paola Arosio): “The European Central Bank has rejected a request by Italy's Monte dei Paschi di Siena for more time to raise capital, a source said…, a decision that piles pressure on the Rome government to bail out the lender. Italy's third-largest bank, and the world's oldest, had asked for a three-week extension until January 20 to try to wrap up a privately funded, 5-billion-euro ($5.3 billion) rescue plan… The ECB's supervisory board turned down the request at a meeting on Friday on the grounds that a delay would be of little use and that it was time for Rome to step in… The Italian government is expected to intervene in the next few days to recapitalize the bank to avert the risk of it being wound down, according to banking sources…”
Monte dei Paschi, Italy’s third-largest bank, saw its shares halted Friday down 10%. With a private-sector recapitalization now in doubt, a government rescue would test the EU’s new rules for forcing “bail in” losses upon bondholders. Italian banks have sold large quantities of bonds to unsuspecting retail customers, creating the potential for significant political fallout in a period of already heightened public anger. There are also the serious issues of further capital flight out of Italy and even bank runs.

One doesn’t have to search far to explain the markets’ sanguine view of Italy - and the world more generally. The ECB extended its QE program – previously scheduled to conclude in March - through the end of 2017. Curiously, in his Thursday press conference Mario Draghi noted that financial markets have “proved much more resilient” than expected, crediting well-capitalized financial institutions and robust supervisory and regulatory regimes. Surely Draghi appreciates that QE is fully responsible for global markets increasingly content to dismiss risk.

It’s astounding how far the Draghi ECB has drifted away from core founding principles. 
Former ECB president Jean-Claude Trichet would regularly repeat “the ECB never pre-commits on rate policy.” This was an critical distinction from the Federal Reserve that under Greenspan became too fond of using prospective rate moves to manipulate market behavior. Federal Reserve policymaking incentivized speculation and was instrumental in nurturing an increasingly unwieldy global pool of speculative finance. Global policies since the 2008 crisis have spurred the expansion of speculative finance to multiples of pre-crisis levels. It’s also rather clear that European debt markets have evolved into a bastion of leveraged speculation. Draghi was in no mood to contemplate the party ever ending.

Thursday’s ECB announcement created some confusion in the markets. While QE was extended through the end of the year, the size was reduced to 60 billion euros ($64bn) monthly from 80 billion. Draghi sternly shot down attempts to label the move as “tapering,” adding that it “has not even been discussed. In fact, it’s not even on the table.”

Bundesbank president Jens Weidmann apparently voted against extending the QE program.
Surely he and other German policymakers were even more disappointed in Draghi’s post-meeting comments.

I believe history will view it was a serious mistake that the ECB did not use Thursday’s meeting as an opportunity to commence the process of weening the markets away from QE. Better to use the current “Risk On” backdrop to impose some reality as opposed to nourishing the beast. 
Worse yet, Draghi signaled that the ECB would continue backstopping the markets indefinitely. He spoke of “open ended” QE and stated that the ECB would be operating in the markets for “a long time.” Draghi stated that “uncertainty prevails everywhere,” implying that markets can strut with absolute certainty of “whatever it takes.” With Draghi’s assurances that QE could be boosted if necessary, the markets are more confident in an expanding program than one that will wind down at the end of 2017.

December 9 – Reuters (Paul Carrel): “Mass-selling German newspaper Bild heaped criticism on European Central Bank President Mario Draghi on Friday, a day after the ECB said it would extend its massive stimulus programme for the euro zone. ‘When does Draghi's money bomb go off?’ Bild asked, with a picture of the Italian's face on a bomb with a lit fuse. The ECB has already spent more than 1.4 trillion euros buying bonds and is at risk of running out of assets. Germany's Bundesbank argues that this blurs a legal line and amounts to financing of government budgets… German Finance Minister Wolfgang Schaeuble… has called on the ECB to start unwinding its expansive monetary policy. ‘The ECB chief is again putting billions at the disposal of crisis countries,’ added Bild…”
The German DAX jumped 6.6% this week, with France’s CAC 40 up 5.2%. Stocks were up 6.6% in Spain, 5.1% in Portugal, 4.3% in Ireland, 4.1% in Switzerland and 4.3% in Greece. Meanwhile, bond yields moved higher. Yields rose 14 bps in Italy and 20 bps in Portugal. And with French yields up 9 bps to near 11-month highs, political risk has begun to make its way into France’s debt instruments.

December 9 – Bloomberg (Piotr Skolimowski and Mark Deen): “The European Central Bank’s latest extension of quantitative easing contains ‘a form of warning’ that unprecedented monetary stimulus is not going to last forever, Executive Board member Benoit Coeure said on Friday. ‘Sources of growth that aren’t dependent on monetary policy need to be found. Long-term rates will rise… Economic players need to be ready, notably governments that have benefited a lot from falling rates.’”
While expected to be down somewhat from 2016’s nearly $2.0 Trillion, global markets remain confident in the immensity of 2017 QE liquidity injections. The ECB has committed to about $800 billion, while the BOJ is poised to purchase huge quantities of JGBs as global yields rise. 
With printing as far as the eye can see, where’s all this “money” going to go?

The DJIA gained almost 600 points this week to another record, as the index rather rapidly approaches 20,000. The S&P500 jumped 3.1%, also to an all-time high. In the broader market, last week’s pullback proved short-lived. The small caps surged 5.6% this week, with the midcaps up 4.2% - both to record highs. The Russell 2000 has surged almost 17% since the election, with the Banks (BKX) up 23%. The Banks added another 5.4% this week, increasing 2016 gains to 27.2%. The broker/dealers rose 4.5%, increasing Q4 gains to 22.8%.

With stocks on the fly, an additional moderate increase in yields caused little market angst. 
Ten-year Treasury yields rose eight bps to 2.47%, the high since June 2015. (Sumit Roy): “Investors continued to plow money into ETFs at a breakneck pace during the first week of December. After adding $48 billion to U.S.-listed ETFs in November, they added $14.6 billion to the space in the week ending Thursday, Dec. 8. Year-to-date inflows now total $229.5 billion… That puts 2016's flows within range of 2014's record annual flows of $244 billion. Once again, U.S. equity ETFs took in the largest haul of the weekly flows, at $11.4 billion.”
Donald Trump can be excused these days for brimming with over-confidence. The President-elect is emboldened, and record stock prices play right into the audacity of it all. Trump is on a mission, and few these days question his determination to go about things differently. He energizes “thank you tour” crowds with rhetoric that would have traditionally receded right along with campaigning. In contrast to Draghi, Trump examines the backdrop and sees an opportunity for boldness. I would imagine Chinese officials monitored his comments this week with rising trepidation – and annoyance. Is Trump laying the groundwork to confront the Chinese?

December 8 – Reuters (Emily Stephenson): “President-elect Donald Trump said on Thursday the United States needed to improve its relationship with China, which he criticized for its economic policies and failure to rein in North Korea… ‘China is not a market economy,’ he said. ‘They haven't played by the rules, and I know it's time that they’re going to start… You have the massive theft of intellectual property, putting unfair taxes on our companies, not helping with the menace of North Korea like they should, and the at-will and massive devaluation of their currency and product dumping,’ Trump said of China. ‘Other than that, they’ve been wonderful, right?’”
December 8 – Bloomberg (Jennifer Jacobs, Mark Niquette , and David Tweed): “U.S. President-elect Donald Trump vowed that China would soon have to ‘play by the rules,’ as Chinese state media issued its clearest warning yet about its bottom line on Taiwan. ‘China is responsible for almost half of America’s trade deficit,’ Trump said at a rally Thursday evening Des Moines, Iowa. ‘China is not a market economy ... they haven’t played by the rules, and they know it’s time that they’re going to start. They’re going to start. They’re going to.’”
December 7 – Financial Times (Hudson Lockett): “China’s foreign exchange reserves fell nearly $70bn last month as the country’s central bank burnt through more of its war chest in its battle to defend the renminbi from greater depreciation on the back of accelerating capital outflows. Reserves at the People’s Bank of China fell $69.1bn to $3.051tn in November, a decline of 2.2% from the previous month and the largest drop since a 3% fall in January… The fifth consecutive monthly fall points to growing difficulty for policymakers. Since a sharp renminbi depreciation in August 2015, Beijing has sought to combat more severe softening against the dollar by selling the US currency from the central bank’s forex reserves.”
China is today unusually fragile. It’s maladjusted Bubble Economy is vulnerable to any slowing of Credit growth. Its rapidly inflating financial sector is an accident in the making. It’s bloated export sector is increasingly uncompetitive globally. China’s currency is susceptible to ongoing massive outflows – “hot money,” corporate and the Chinese household sector. And each of these serious issues is being aggravated by U.S. election results and resulting higher yields and king dollar, along with prospects for a more active Federal Reserve.

In a normal environment, markets would be reacting nervously to Trump’s unorthodox comments, tweets and positioning on China. But melt-up dynamics are the current fixation. It’s easy these days to ramble on about lower corporate taxes and deregulation than to ponder the ramifications of President Trump moving early in his administration to confront the Chinese on trade and currency manipulation. This would be a dicey fight on behalf of U.S manufacturing and the American worker – with the indomitable equities market potential collateral damage.

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