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Calm seas but storm clouds loom

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Loose monetary policies across developed markets, a more balanced banking sector and stable growth in several emerging countries have resulted in steady improvements to Europe’s economic outlook over the past year and a half. It did not happen at once, and it is not uniform yet, but the continent is doing fine: unemployment levels are lower, and the ECB’s GDP growth forecast for the EU is still at 1.9% for both 2017 and 2018. Most (if not all) statistics on economic activity show incremental gains, and sentiment indicators have improved further since Macron’s election as French President. The ’new wave’ of political debates, focusing on stimulating EU growth and infrastructure investments rather than public spending cuts, will underline of this idyllic moment for Europe in the medium term.

The improved conditions are well-demonstrated by the EUR/USD risk reversal (R/R). This is a measure of the difference in the cost of options which protect against EUR appreciation and those which offer equivalent levels of protection against its depreciation. On EUR-USD, a positive R/R implies an expectation by the market that the EUR is more likely to strengthen than to weaken in the short term. By this metric, ever since 2009 and with a peak in 2011, the market has been persistently showing higher demand for EUR Put options than EUR Call options. Since 2015 the R/R has been flirting with a more neutral position, and has recently, following Macron’s election, reached its highest level since 2009. 

Fear not, dear risk managers: EU political and financial risks have not disappeared. Climate change and fintech have accelerated the speed at which storms gather, and damaging deluges will continue pouring over the region and its financial markets. For as much as I would like to talk about upcoming spring and summer festivals, I need to share some views on (who else?) Italy. There a new storm is gathering, and you would be well advised to diarise market volatility for September 2017, as well as the ensuing uncertainty for the following semester. The Government is still ’running’ the country, but party leaders are focusing more and more on finding a one-size-fits-all electoral law which is very likely to deliver a weak structure of government. Meanwhile, the present government is avoiding taking any decisions which could cause friction, and are kicking the can down the road with regard to any substantial financial issue the country is facing. This covers not only the 133% debt–to-GDP ration, but also the defaulting Alitalia, Banco Popolare di Vicenza and Veneto Banca, as well as the ’precautionary’ VAT hike of 3% to reduce budget deficit, due on Jan 2018.

Alitalia went into crisis in April when, after two years of losses and worsening outlook, a weak restructuring proposal was shut down by both employees and the lenders. Alitalia is private, but still ‘flagship’ for all those politicians who cannot risk losing the 12,500 voters who would lose their job in the event of its failure. The company is now in administration: the Government guaranteed a bridge loan for six months (due in October) which, in typical Italian fashion, was presented to the public as being for €300 million and then subsequently swelled to €600 million in order to enable the airline to continue operating. The administrators will have six months to find a buyer and/or prepare the business for liquidation.

Having tackled the problems faced by Monte dei Paschi di Siena (MPS) – outsized, but at least operationally profitable – along with those of four distressed regional banks, mending the broken piggy bank of Banca Popolare di Vicenza and Veneto Banca is proving extremely difficult. Both banks have been taken over by Fondo Atlante, a fund created by the state to bail out strategic banks in distress, but mostly funded by large, private financial institutions. The investment plan – a merger of the two entities intended to result in substantial cost efficiencies – is predicated on a precautionary recapitalisation from the Italian State, which the ECB can approve only if the two banks are proven to be solvent independently. Such proof will be incredibly difficult without Fondo Atlante committing a further €1.2bn to the investment, which it does not have at the moment, or the bail-in of subordinated bondholders (most of them being retail savers, victims of the mis-selling of an unsuitable investment product by the same banks). To avoid the bail-in, and related political damage, the Government is trying all (transition/interim) avenues; most commentators are wary that a politically friendly solution is not possible within the current European regulation framework.

Thanks to the ECB, Italy can borrow at very cheap rates, but the country’s deficit is under strict control as it is bound to reduce its debt to GDP ratio over the medium term. Among the many agreements closed over the past years between Italy and the European Commission (EC), one identified a deficit improvement by some €15-19bn by January 2018. The Government committed to increase VAT by 2-3% in January 2018 to cover the balance in case Italy could not meet the target. As no politician, or leading party, would want to be associated with a VAT increase, Prime Minister Gentiloni and Finance Minister Padoan are trying (probably also by playing poker overnight) to find the money and avoid activating this fiscal measure. In the meantime, they are trying to agree with the EC to postpone it to April 2018 as a nice gift to the new Government.

So, even though you may have thought that the German elections proved no uncertainty and September was going to be piece of cake, we may come back from holidays with another smashed wasp’s nest in Europe. 

All views expressed are the author's own and are based on information available at the time of writing. 

 

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