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Friday, 2nd December 2016

As the Trump Rally Fizzles, Attention Turns Back to Reality  

The Trump stock rally has finally slowed, right on schedule. As reported here earlier, the Reagan rally following his election in 1980 ended on November 30 and did not resume for more than two years. 

Perhaps now the market can begin to give attention to the real problems in the financial system. Our personal favourite is the Italian banking system which has the added significance of a short term catalyst to grab market attention.

The Financial Times reported last week that as many as eight of Italy's troubled banks "risk failing" if prime minister Matteo Renzi loses the constitutional referendum to be held this coming Sunday, December the 4th.

Renzi has promised to resign if he loses this referendum and his government would then fall, threatening to end his plan to recapitalize the €4 Trillion Italian banking system. The resulting market turbulence could scare investors away from an urgent need to recapitalize Italian banks. The latest polls show Renzi losing the vote.

The alternative to Renzi's plan is a "resolution" under E.U. rules. Resolution is a recently-approved, Germany-sponsored regulatory mechanism which restructures and, if necessary, winds up insolvent banks by imposing losses on both equity and debt investors (a so-called "bail-in"). This process would be particularly devastating in Italy where millions of individual investors have invested their savings in junior bank bonds. Flexibility has been rejected in advance by the Merkel administration.

The situation is being closely watched by financiers and policymakers across Europe and beyond, who worry that a failure of Italian banks could trigger panic across the euro zone banking system.

The problems at the banks stem from the Italian economy which has never recovered from the 2008 crisis. Gross domestic product per head is 9 per cent lower in real terms today than it was in 2007 and remains stuck near the level of two decades ago. Italy staggers under an ageing population and the second highest public debt load in Europe at more than 130 per cent of GDP.

Italy's financial system is based on small, co-operatively-owned banks which have traditionally put their role of supporting local economies above profitmaking. The country is wildly overbanked, with more branches per capital than any other industrialized country. This structure, and the lack of economic growth, have suppressed profits at all banks while non-performing loans have soared. Bad debts have not been written off as Bank of Italy inspectors have turned a blind eye, waiting hopefully for an economic recovery that never came. That's why the market value of Italian banks has fallen by more than half this year.

Furthermore, capital is flooding out of Italy, further depressing bank balance sheets and weakening the economy. The flow of capital within the euro zone is tracked by the ECB's Target 2 system. Italy is experiencing a run on its capital reserves of alarming proportions. The latest Target 2 balances for September 30, 2016 show a net accumulated outflow of €353.9 billion since 2010, up €17 billion in September alone. Carmen Reinhart, perhaps the foremost expert on national debt dynamics, notes that "Italy's Target 2 deficit is above 20% of GDP, its worst reading to date (see graph below). By some of the standard definitions, these are crisis-level reserve losses (shaded in the figure)," she says.

Capital Fright

The market is sniffing out the risks. The spreads on Italian government bonds versus German bunds are at levels not seen since October 2014.

Risk Premium

The problems in the European banking system will not go away with time. The ECB's aggressive bond purchase program has lulled investors into a deep sleep but added liquidity does not fix a solvency problem. The Italian banks have an estimated €360 Billion in bad debts, much of it to insolvent borrowers. Total capital in the Italian banking system is estimated at no more than €225 Billion. These are official numbers so we can assume they understate the problem. Let's see what December brings.