Daily Comment (May 31, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the last day of May!  Markets are mostly steady, the dollar is a bit weaker and Treasuries are seeing a modest bump in yields.  Here is what we are watching this morning:

Italian populists try to form a government: Italy’s president has given the populists more time to form a government,[1] but the League’s leader, Matteo Salvini, has been reluctant to finish the deal, likely hoping that his party’s standing would improve with new elections.  Hopes that new elections could be avoided sparked a strong rally in Italian bonds and a pullback in flight to safety instruments, such as the yen and U.S. Treasuries.  It seems a bit odd that the formation of a populist government is preferred to new elections, but the fear of new elections is that they will turn into a referendum on the Eurozone and Italians will decide to leave.

In reality, the populist coalition in Italy is rather unusual and may not survive.  We have dubbed it a “Nader coalition” of left- and right-wing populists.  Why is this rare?  It’s a bit like the Tea Party and Occupy forming a government in the U.S.  Nader’s argument is that both populist wings share similar goals on economic policy and thus should subsume their social differences to improve their economic conditions.  History shows that a more durable coalition is when a center party aligns with a populist party, with the former giving enough economic “goodies” to the populists to keep them together.  Franklin Roosevelt’s center-left coalition with the white working class lasted from the 1930s into the mid-1960s.

If the populists do form a government, we doubt it will last long.  The League’s base is in northern Italy, which is industrial and economically successful.  The Five-Star Movement is based in economically depressed southern Italy.  That’s why you see a policy mix that includes tax cuts, anti-immigration and basic national income.  The only way such a policy mix works is if the EU simply stops enforcing fiscal rules.  However, the financial markets will pressure Italy if such policies are adopted.  If we get new elections, look for fear to pressure financial markets but, in reality, new elections are probably necessary and we don’t see Italy leaving the Eurozone in the short run.  In fact, about the only way Italy exits the Eurozone is if Five-Star dominates the government.

Trade war looming?  The deadline for steel and aluminum tariff exemptions is tomorrow and there is every indication that the Trump administration is moving to implement some form of tariffs, although a short-term waiver is possible.  If trade actions are taken, we expect the U.S. to implement quotas on imports, with tariffs applied once the imports exceed the quota level.  The real worry is retaliation.  We would expect all nations adversely affected to apply their own trade retaliation.  Expect the retaliation to be targeted to politically sensitive areas of the economy, including agriculture, bourbon and motorcycles.  The tariff threat could also kill this weekend’s scheduled talks between Commerce Secretary Ross and Chinese officials.

Rajoy in trouble: The formal debate to hold a confidence vote on the current Spanish government begins today.  Rajoy might survive even though his support is weak because of party rivalry; voting Rajoy out puts the Socialists in power, which the center-left parties don’t want.  We expect the eventual outcome to be new elections.  Although political turmoil is a bearish factor for confidence assets, this problem is more normal.  What is going on in Spain is all about domestic issues, while Italy affects the foundation of the Eurozone.  Thus, we would not expect Spain to turn into a Eurozone crisis.

A hawk flies away: The BOE’s Monetary Policy Committee bid adieu to Ian McCafferty and announced that Jonathan Haskel will be joining the group.  McCafferty has been a recent dissenter to steady policy, voting to raise rates.  It is unclear how Haskel will vote.  He is an economics professor and specialist in productivity and growth measurement.  Most likely, the committee has become a bit more dovish.

The OECD boosts growth forecasts:The OECD is forecasting global GDP to rise 3.8% this year, up from its last forecast of 3.5%, mostly due to stronger U.S. growth.  Although the strong dollar’s impact on emerging markets was noted as a risk factor, the group remains optimistic about the near term.

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[1] https://www.ft.com/content/91937214-63d4-11e8-90c2-9563a0613e56