Italy means risk-off yes, but contagion will remain limited

A quick follow up here on Italy just for the more financially-minded of you. I don’t see anything existential happening in the near-term because of Italy. We are seeing a flight to safety and that supports the US dollar and safe assets like US government bonds or German Bunds. But Italy is not going to have much further contagion given where we are in the business cycle.

If you look at the rest of the periphery in Europe, Spain’s gross domestic product rose by 2.9% year-on-year in the first quarter of 2018. Portugal’s grew 2.1%. Ireland’s last numbers I have are for Q4 2017 and that number is 8.4%, though the accounting is problematic. Even the Greek economy grew 1.9% in 2017.

That’s a very different position than we were in in 2009, when (Dubai World and later) Greece started the first sovereign debt crisis. I don’t see the makings of exogenous shocks here, just minor adjustments in risk.

That says to me that the contagion from Italy will occur not as a result of economic vulnerability but as a result of economic slowing or policy error.

In the case of policy error, I am talking about the ECB principally. As long as Italy’s political situation deteriorates, markets are going to test the ECB on “whatever it takes” until the ECB is forced to react. But all the ECB has to do is re-commit and that assault on Italy is thwarted.

What if they don’t? Then you get yields in Italy rising and bank shares and bank capital falling to the point where real contagion begins, not just in Italy but elsewhere given German and French bank exposure to Italy. Deutsche Bank is particularly weak right now, for example. And that is a bank central to the German economy and fully integrated into global financial markets, more so than Lehman Brothers.

These are the risks the ECB would be playing with if it didn’t eventually step in. I believe it will, if things start to get out of hand.

In the case of slowing, let’s look at the US as an example. Right now the Fed is raising rates because it believes the pace of economic growth and the tightness of the labor market warrants doing so. Markets are sceptical. And we can see that in the flattening of the yield curve.

Now if you look at the credit data, you are starting to see bad things. For example, the Wall Street Journal reported this morning that “auto loan delinquencies are too high considering the strong economy“. Here’s the part to key in on:

Credit-card loans that are more than 90 days delinquent rose to 8% of total balances in the first quarter from 7.5% a year earlier, according to Fed data. The portion of delinquent auto loans rose to 4.3% from 3.8%.

And the Journal had this chart to accompany that analysis.

So, despite the robust headline macro numbers, underneath we see credit weakness in both the auto sector and in credit cards, particularly at small banks.

Rising rates and a flattening yield curve will only accelerate this process. Add in the impetus from Italy compressing the curve and driving up the US dollar, and at the margin you have yet more pressure at just the wrong point in the cycle.

For now, think of Italy as a short-term risk-off trigger that has limited longer-term impact. We would need to see a major policy error from the ECB for Italy to produce contagion that imperils the financial system or the real economy. To me, this presents a buying opportunity.

At the same time, we are very near the end of this business cycle. And Italy’s problems are not going to go away. This will exacerbate US curve flattening, boost the US dollar and modestly accelerate end of cycle credit dynamics. I still see 2019 as the year when the fireworks begin. Italy is just an appetizer.