Dancing with Contagion

BBH CurrencyView

• Markets have shifted back to crisis mode amid uncertainty over Italian economic reforms
• Three likely scenarios remain after Berlusconi’s upcoming departure; Italian 10-year above 7%
• UK September trade data unexpectedly widened, on imports; China’s October CPI eases

Market sentiment took a material turn for the worse in the European session following a rather strong Asian session as Italian politics continue to dominate the headlines. The move out of risky positions saw a sharp rise in the euro zone risk premium, with the front-end of the Italian yield curve inverting (2-year yield > 10-year yield), together with the 44bps rise in the Italian 5-year CDS contract. Italian yields also surged in part after LCH Clearnet raised its collateral requirements on Italian debt, prompting further liquidation. European banking shares plunged over 4%, while gold continues to reasserts it positive correlation with stocks. In sum, markets have quickly shifted back to crisis mode and as a result the dollar and yen are broadly firmer.

Italian political developments continue to remain front and center after Berlusconi promises to resign once the austerity measures are approved. Berlusconi’s loss of an absolute majority in yesterday’s budget vote has prompted him to announce his resignation, albeit only after the vote on stability measures next week. The measures include the sale of public real estate and the reform of public services, but both are unlikely to fully attract the market’s confidence, since they fall short of tackling the politically sensitive pensions and labor market. In turn, the markets have taken the latest developments with an air of skepticism and in turn the 10-year Italian bond yield is currently trading at 7.359% and the Italian CDS price is up 43bps. So what is the next step? In our view the most likely scenario, in the coming weeks, is that the current coalition rally around another PM candidate that it feels can gain domestic and international confidence. To be deemed credible, though, this new government would need to address the politically sensitive pension and labor system. This would be supportive for risk appetite and the euro in particular. The second most likely scenario is one where a “technocratic” government is formed as was done in the 1990s and more importantly is likely more effective at dealing with governance and the economic reform issues. Because of its expediency this is likely the most market friendly outcome. The last outcome would involve early elections. This, however, would be the worst outcome for sentiment as it would increase uncertainty and of course stall progress on economic reform. From here, amid the rise in uncertainty it is likely that the euro remains under pressure until there is more clarity on the outlook for reform. We continue to think that the 1.385 remains key resistance with support resting between 1.357-1.36.

Elsewhere in Europe, the UK September trade deficit unexpectedly blew out to a new series record, driven by a sharp rise in imports. The August deficit was also revised higher. The September data more than offsets what had seemed a good August report at its initial release, when surprising export strength had seen the visible trade deficit come in narrower than expected. The total merchandise goods deficit came in at £9.8bln, above the market consensus for £8.0bln, while the August figure was revised out to £8.6bln from £7.8 bln. In the same way, a similar picture was seen in the non-EU deficit figure. September imports, meanwhile, spiked by £1.2bln, bringing total imports of goods to £34.3bln, a post-1998 high, while exports rose by less than £0.1 bln. Altogether, the data is likely to be worrying for policy makers seeking to rebalance the UK economy. While it is hard to see how imports increased so substantially against the backdrop of weak domestic demand, looking ahead we suspect the trade deficit is likely to remain substantial amid the expected weakening in exports as euro zone economic activity contracts. All told, this data continues to underscores the weakness in UK activity.

No big surprises from China’s economic data overnight but the figures are nevertheless market friendly developments. CPI declined from 6.1% yoy in September to 5.5% yoy in October with food prices down substantially. Looking ahead, further high frequency data reported indicates that food prices are likely to have moderated and may in fact lead the November CPI print to fall below 5%. The UN’s World Food Price Indeed has in fact fallen by nearly 10% since its recent peak in early March. What’s more, PPI fell by more than expected from 6.5% yoy to 5.0% yoy driven lower by manufacturing and raw materials. Retail sales and industrial production are still healthy, in line with our soft landing scenario. It is still expected to keep measures in place to cap property prices and if it does ease it will likely target the bank reserve ratio first, rather than cutting interest rates. Altogether, though, the data reaffirms our view that we are moving into a period of selective easing in China. This should be seen as positive for Chinese assets in particular and EM/AUD & NZD in general.