Italian Prime Minister Matteo Renzi looks on during a media conference after a referendum on constitutional reform at Chigi palace in Rome, Italy, December 5, 2016.Alessandro Bianchi/Reuters
Let me start off by saying I love Italy — the country, the people, the history. I've made some of my best memories there. As an investment, however, it's been horrible since adopintg the euro in 1999.
The recent failed constitutional referendum was yet another vote against the sitting government in a country that has had 63 different administrations since 1945. The economy has some chronic problems that no government has been able to address for decades.
In the 1980s and 1990s, the lira fell from 450 to 1 against the deutschemark before peaking at 1250 in 1992 when Italy, the UK and Sweden exited the Exchange Rate Mechanism (the first iteration of the euro currency). Italy's stock market outperformed Germany's by about 1 per cent per year over that period, while its industrial production beat Germany by a total of 10 per cent when its currency was weakening.
But since entering the euro in 1999, the Italian economy has underperformed its German counterpart by 40 per cent and its stock market by 65 per cent. The need to go back to the lira and get out from under EU regulations will dominate the upcoming elections. At the moment, we do not know when they will be, but likely sometime in the first half of 2017 given how badly Prime Minister Matteo Renzi lost the referendum.
Several Italian banks are on the verge of bankruptcy. EU regulations will not allow them to be fixed in a manner that does not hurt depositors, which is a political bomb for Italy's older population, who have been sold on the safety of bank bonds. You do not need to look too much further than the over €300-billion of non-performing loans to see how challenging the problem is. By some estimates, Italy needs to stuff €100-billion or more in to recapitalize the banks, and that would still not fix their structural growth problems. It is the most indebted nation in the European Union next to Greece.
Italy is too big to fix; it therefore must be allowed to fail. That failure would be that they vote to leave the euro and go back to the lira. It's inevitable.
So why then are we seeing the Italian stock market ETFs (EWI-N, HEWI-N) turning the corner and breaking out? Keep in mind that the stock market is a discounting mechanism. It was widely expected that Prime Minister Renzi was going to lose the referendum, and the market tends to sell the rumor and buy the news. We have seen many failed rallies for several years in the Italian market, and we expect that this time is no different. There could also be some hope that the European Central Bank (ECB) will throw a bunch of money at it like they did with Greece and others to stabilize the bond market and lower borrowing costs. The ECB's "we will do everything we can" mantra has caused a huge misallocation of capital that was extended again this week. There is no way a country on the brink like Italy could see its debt trading at a lower yield than U.S. Treasuries were it not for the ECB buying the debt.
We have said for years that the EU will eventually break apart. Brexit was the first shot across the bow, and Italy just punctured a hole in the hull.
For our global portfolios, we are most underweight Europe because the probability of the EU breaking apart in the coming years is increasing. Where we do have exposure to Europe, it's with the high-yielding ZWE-T (BMO European High Dividend Covered Call – CAD Hedged), which has almost no exposure to Italy.
The U.S. market remains the best dirty shirt in the laundry, and while I'm bullish on reforms seemingly developing under Trump, the EU breaking apart will almost certainly cause a global recession; it is too big and systemic not to have that kind of impact and could take years to fully play out.
There is some "irrational exuberance" building, and that is when portfolio risk is greatest. Alan Greenspan, former head of the U.S. central bank, used that now-infamous term in December 1996, and the ultimate market exuberance did not end until 2000. As a rule of thumb, when the markets get irrational, one should get defensive. Defining irrational exuberance at market tops is extremely difficult compared to measuring panic and fear at market bottoms.
As gold sells off, I'm starting to like the idea of holding the GLDI-Q, an ETF that writes call options on the bullion position to generate a yield while holding gold. The massive increases of debt that the markets are cheering is transferring a huge burden to coming generations, and this will continue to crowd out growth and productivity. Eventually the piper will need to be paid.
Do you want to learn more about how to do this in your portfolio? I talk about how to build smarter ETF portfolios in my 2017 educational seminars. Registration is free at a city near you and you can follow me on my new blog or watch me on Berman's Call Mondays at 11 a.m. ET. Follow me on Twitter: @LarryBermanETF on Facebook: ETF Capital Management.