Disillusionment In Europe

There are a few stories I’ve been following in Europe which I will discuss in this article. I will discuss the recent European CPI report, the problems facing UniCredit, and the political risk in France. All the issues in Europe are related. The seams of the social contract in Europe are fraying. What I mean by this is the people don’t trust the government. This leads to a volatile situation where a politician who moves the Overton Window can gain power. The Overton Window is the range of what ideas are acceptable in public discourse. The people aren’t acting irrationally; it’s the government which has gone awry. The European Central Bank is buying corporate bonds, the Italian banks are losing unfathomable amounts of money, many of the countries in Europe have debt to GDP ratios above 100%, immigration has gotten out of control, and the underground economies are allowed to flourish.

Monetary policy isn’t generally part of the public discussion, but if it was I’d consider buying corporate debt to be far outside the Overtone Window 10 years ago. It can only end in disaster. There’s no way to unwind it. It creates inefficiencies in the system when firms can borrow at below the market rate. The most prominent problem is firms aren’t inhibited from taking high risk because they will always have the government to backstop them. It’s the definition of a morale hazard. The policies in action today are like the which caused the 2008 financial crisis except on steroids.

In a previous article, I mentioned the CPI in Germany rose to 1.9% which is near the 2.0% limit for all of Europe. The 2% inflation rate is a hard ceiling, which would necessitate ending the $60 billion per month QE program and possibly cause rate hikes. I mentioned that it could spur political risk if it came in below expectations because Germany would be feeling the pinch from high inflation without any policy responses from the ECB coming to the rescue because it can’t only focus on one member state. However, this didn’t happen as the inflation rate was 1.8% which was above the 1.6% expectation. This was the highest level since February 2013. However, policymakers are pointing to the 0.9% core inflation rate as the reason to not turn hawkish.

It’s a great scenario for the ECB because the German inflation rate isn’t getting too far ahead of the total rate. Secondly, the core inflation is moderate so no hawkish action is needed. Ending the QE program would force the Italian banks and government to see the sunlight of open markets. The political risk already caused Italian yields to increase even with the bond buying program. It could easily spiral out of control because high yields cause political pressure and when tensions rise, it causes yields to rise. The ECB has saved the Italian economy. It doesn’t want to walk away quicker than it has to because the situation isn’t resolved yet.

This brings me to the problems Unicredit has faced which I mentioned briefly in a previous article. Unicredit is Italy’s largest bank and the only one deemed systemically important. Unicredit reported that it lost 11.8 billion euros in 2016. It certainly needs the major restructuring it is about to go through. It’s not a coincidence that most of the Italian banks are having problems. The economy has structural issues which need to be resolved. The bank booked 12.2 billion euros in charge offs. It also booked a 1 billion euro loss from its contribution to the bailout fund Atlante and the National Resolutions Fund. The bank is attempting to purge the bad loans from its balance sheet. It plans to sell 17.7 billion euros in bad loans as part of this process.

The ECB has found problems with Unicredit such as its 8% Common Equity Tier One Ratio which is below the 8.75% minimum, low profitability, high bad loans, high costs in Germany and Austria, and high risks in Turkey and Russia. In my opinion, this is mainly noise because the bank is going to get every opportunity to succeed given its importance. That’s not to say these next few weeks won’t be rocky. Unicredit’s stock has fallen about 14% in the past 3 days due to uncertainty on how this process will play out. The bank will present a plan on how it will deal with its bad loans to the ECB on February 28th. Unicredit is attempting to reach a Common Equity Tier One Ratio of 12.5% by 2019.

Unicredit has plans to issue 16.5 billion euros in a stock offering which is larger than the market cap of the company. The offering could come as early as next week. The details will be sorted out when the board meets on Wednesday. The bank reports earnings next Thursday, so we’ll get more details on the specific challenges the bank faces.

The political risk in France is the slim possibility that Marine Le Pen wins the presidential race. She wants France to exit the European Union which is why she is considered a risky candidate by the market. She’s winning in the polls for the first round of voting, but she loses heavily in the run-off polls which pit the top two candidates against each other. The first round is April 23rd and the runoff is May 7th. The chart below shows the bond market is pricing in heightened risk which is why the spread between the French and German bond yields is at the highest point in months. The global trend toward populist candidates winning will be halted if she loses.

Conclusion

Europe is disillusioned politically. The inflation rate is increasing, but it may not affect the ECB’s asset purchases because the core rate is stable. To me, this is a cop out and an example of why trust in the government is waning. While global populism has been on the rise, it looks like it won’t make its way to France since Marine Le Pen is projected to lose the presidential election on May 7th.