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The World Is But a Few Steps Away From a Financial Crisis Lombardi Letter 2018-06-27 12:40:32 EU Europe European Union eurozone Italy migrant crisis global recession economic depression BTP Bund Political risk from Europe (not to mention other areas) now has grown far beyond what it was in 2017. This means that a major financial crisis is but a few steps away. Analysis and Predictions 2018,News,Stock Market,Stock Market Crash,U.S. Economy,U.S. Politics,World Politics https://www.lombardiletter.com/wp-content/uploads/2018/06/iStock-471695231-150x150.jpg

The World Is But a Few Steps Away From a Financial Crisis

World Financial Crisis

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Italy, Migrants, and the European Union Control the Fate of the Inevitable Next Financial Crisis

A year ago, it seemed that Europe managed to avert a financial crisis that threatened a repeat of September 2008.

However, “surprising” economic data and Emmanuel Macron’s win over “populist” Marine Le Pen in the French presidential election produced a bullish rebound effect.

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Political risk dropped and equity markets around the world had air to breathe another day—even another year.

A financial crisis was averted.

Yet, that effect has waned. Political risk from Europe (not to mention other areas) now has grown far beyond what it was in 2017.

China Isn’t Helping

Adding to this is an evident—if undeclared—bear market in China, where investors fear the effects of a brewing trade war with the United States. Meanwhile, the U.S. stock market is about eight percent off its January record.

Back to Europe, North American banks are downgrading European equities from “market weight” to “overweight.” And stocks, like airplanes, perform better when they’re not carrying too much baggage.

Europe has long passed the “overweight” moment, in risk terms.

Economic performance has worsened, even before the most pessimistic expectations. Yet, thanks in no small way to President Donald Trump’s trade wars, nobody has the brakes to stop the financial crisis from ending the current—limited though it has been—phase of economic growth.

Trump (or his advisors) has shaped his policies with a view toward isolationism. But the rest of the world, for well over two decades, has adapted to the realities of free trade.

Adapting to Tariffs Will Cause Turmoil

For better or worse, a return to tariffs and barriers needs time to work and to allow the various players to adapt.

There are no assurances that the adaptation will work. Nevertheless, you can rest assured that unemployment will increase globally.

In the post-Cold War era, developing countries (most of the world, even when you exclude China and India from this group) have built their economies following prescriptions from economists in the West.

Technocrats have subscribed to The Economist, scrutinized the Financial Times, and heeded the mantras from the International Monetary Fund (IMF) and World Bank with religious devotion.

Now they have been forced to change—suddenly. The developing countries have been forced to recognize that the world is often fickle, and economics more so.

Now the citizens of developing and developed counties alike could discover that America’s sudden preference for reciprocal tariffs could lead to another major financial crisis.

Tariffs Could Lead to Economic Depression

A financial crisis could hit the United States hardest of all among the developed countries.

Between sanctions here (Russia, Iran—both major oil and resource producers) and tariffs there (Europe, Canada, etc.), the U.S. has been pursuing a self-inflicted path to oblivion.

The sanctioned and tariffed states will come together and establish trade agreements among themselves—and exclude the United States.

Yet, that too is optimistic, because there will have to be some kind of world economy to begin with. And a key component of that economy, the European Union (EU), must overcome significant obstacles.

Economic statistics, including key indicators such as purchasing power, point to a return of decline. Yet, as alarming as the latest economic trends might suggest, the real risks are ahead and rather intractable.

The Financial Crisis and the Dublin Treaty

The European project risks being shattered over disagreements to reform the Dublin Treaty.

The Dublin Treaty sounds innocuous enough, but it has become the very point over which hangs the fate of the EU.

The Dublin Treaty, in basic terms, regulates the distribution of asylum seekers trying to enter Europe, holding that the country of their first port of arrival is responsible.

Yet, the legitimate asylum seekers are few. Less than 10% are recognized as refugees. Thus, they’re supposed to be expelled. Yet, often they’re not.

Moreover, the Dublin Treaty has unloaded the brunt of the burden on Italy (and Greece, to a lesser extent). Both countries have endured difficult economic situations, stemming from the 2008 financial crisis. In fact, neither one has fully emerged from that crisis yet.

Recently, a new Italian prime minister, backed by parties that want to revise or even scrap the Dublin Treaty, has tried to redistribute the burden among other EU states.

However, nothing concrete has happened. The new government could decide to leave the EU. This would mean Italy leaving the eurozone and the collapse of the euro.

European Union Institutional Crisis

Fear about Italy’s exit from the EU—”Quitaly,” as some call it—intensified at the end of May. A new government was formed, but that government is made up of parties that would, in normal circumstances, be in opposition to each other.

The first effect of a Quitaly needs no expert to predict. Clearly, Italy leaving the eurozone would be a big blow to the single currency. Italy is a founding member of the EU and is second only to Germany in export value.

The new government must solve the migration problem or face dissolution. And that would trigger demands for a referendum or another vote, centered on leaving the euro.

A threat of a government implosion in Italy should be enough to set off a financial crisis.

World markets would collapse and EU bond yields—at least those issued in the so-called PIGS (Portugal, Italy, Greece, Spain)—would go through the roof.

Investors likely have few illusions about the Italian state’s ability to repay its debts.

It’s All in the Spread

For those less interested in reading up on international events, the infamous “spread” has become the key indicator of EU financial risk.

The spread refers to the yield difference between Italian government bonds (BTP) and German government bonds (Bund). The higher the BTP/Bund spread goes, the higher the economic risk.

As it happens, the spread has achieved its highest values in years. In early June, it exceeded 300 points. The formation of an Italian government in extremis helped diffuse some risk, yet, despite that, the spread remains at 260 points.

It won’t take long—or much—to send it back above 300. And the EU will have few tools at its disposal to prevent a political crisis from triggering a financial crisis.

Investors should pay close attention to Italy and the migrant situation. Their fates are linked.

The financial markets have dropped, but have remained relatively calm. Perhaps many traders have been paying less attention, distracted by the FIFA World Cup in Russia.

The new Italian government, however, remains unstable. Europe’s inability to find a solution to the migrant situation keeps the unwelcome shadow of a collapse forcing new elections.

New elections would most likely promote the most populist and intensely anti-Europe forces. The aforementioned spread would explode and the EU would implode.

Should Italy, which remains the third-strongest economy in the eurozone, abandon the euro, there’s nothing stopping all of the other countries from doing so.

It would be a disaster that few would like to experiment with. It would be the financial equivalent of dropping a nuclear bomb. Wall Street would not react favorably.

Would the U.S. Benefit From a Collapse of the Euro?

As trade barriers go up everywhere, many goods will cost more. A financial crisis in Europe would have ripple effects in the rest of the world.

Besides, Wall Street has already shown weaknesses of its own. The Dow Jones Industrial Average has failed to replicate its January success and excess. Therefore, stocks are overvalued.

The U.S. stock market is just looking for an excuse—any excuse—to collapse. And a financial crisis in the European Union would provide more than enough ammunition.

The U.S. Federal Reserve’s policy of increasing interest rates even faster than expected has only rendered the markets more vulnerable as traders who bought on margin (enjoying the low interest) will be forced to sell.

A U.S. stock market crash or financial crisis will not go unnoticed. It will have ripple effects, producing nothing short of a global recession.

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