Brexit - Part Three

While stocks, real estate, and sovereign debt may be in bubbles, there is a bigger bubble than them all. That bubble is the political bubble. Unlike other bubbles, there is no way to measure the feelings of citizens. The polls tend to underrepresent populist support much like analysts over represent earnings expectations. There’s no PE ratio for the support of politicians. However, the political bubble’s burst has much bigger consequences for the future.

It is amazing how these populist swings in elections have occurred without a major economic crisis. If the recovery period has brought about this much change, one can only imagine what will happen when serious economic strife happens in the next recession. This is a chicken and egg scenario. Is political strife causing the economy to weaken or is economic malaise causing the political tensions? It’s a self-fulfilling prophecy. There isn’t much that needs to happen for the powder keg to explode. These elections may be what does it.

A pattern has emerged. The polls show a close election which the populist movement losing. Then the media claims there is no way for the populist movement to win. Then the populist movement wins. There is nothing shocking about any of the election results if you live outside of a major city. Central banks have tried to help politicians because the politicians are having a tough time generating growth amidst the corruption, regulations, high debt, and gridlock. However, quantitative easing has accelerated the wealth gap as excess liquidity has boosted asset prices and done nothing to help the working person.

The first election was the Brexit. The second election was Trump. The third election will be the Italian referendum vote in December. This is a global trend of right wing populism which has been building for years and has now gained mainstream support. It is very easy for an ideology to grow when the status quo is horrendous. The chart below shows the growth in popularity among various populist parties in Europe. America has had a two party system for over 100 years, so you would think this type of movement would have a tougher time getting through, but it was able to succeed. Trump ran against both parties which provides evidence for the strength of the movement.


The Italian election is December 4th. It will be a referendum on the reforms Prime Minister Matteo Renzi wants to put in place. The referendum proposes to streamline the legislative process by decreasing the power of the country's second chamber, its senate. If the country votes “No” then he may resign and more importantly there may be an election to decide whether to exit the European Union entirely in the summer of 2017. If “Yes” wins, there will be a normal election in 2018. France is the next down the line with its presidential election in April.

I am not an expert in Italian politics, but there were statisticians at the New York Times who had worse U.S. election guesses than I had and they are way more ‘qualified’ at making predictions than I am. If you choose to believe in the myth that Italy being in the EU has helped it, then you will get this next election wrong as you’ve gotten the last two wrong. Italy’s GDP has declined 10% since it entered the EU. It’s GDP per capita is at a 20 year low.

Its banking system is in disarray as 18% of loans are non-performing. The oldest bank in the world, Monte Dei Paschi has been separated into a good bank and a bad bank, but the bad bank keeps needing more money to cover for losses. It recently did a debt to equity swap where tier 1 bond holders took a 15% haircut. Tier 2 subordinate debt was sold to the Italian retail investors which is likely why it didn’t get a cut. This entire scenario of a weak banking system means small businesses and citizens will have a tougher time getting loans. If Monte Dei Paschi does survive this bail-in, it will have much more stringent lending standards to avoid a repeat.

Prior to entering the EU, Italy had relied on currency devaluations to maintain competitiveness. Fiscal spending helped the poor southern part of the country. This is no longer the case in the EU as Italy cannot deflate the Euro and has limits to how much it can borrow to do fiscal spending.

You would think the scenario I have laid out would mean it is obvious the “No” vote would win, but the mainstream media still has its head in the sand. Out of the U.K., America, and Italy, Italy’s economy is in, by far the worst, shape. The Italian election possibly leading to its exit from the EU would also have the biggest consequences of the three. The U.K. still used the Pound and had its own central bank, so it was never fully in the EU to begin with. Italy is fully in the EU and has such a big economy, that some wonder if an ‘Italeave’ could end the entire European Union project.


            The reason why stocks are this high and the media is ignoring the political tidal wave approaching have the same causes. The economic data has a big disconnect from the actual well-being of the people. The politicians and media can get away with lying about certain issues, but they cannot get away with telling someone who doesn’t have a job that the economy is in amazing shape. Bullish investors are stubborn. It will take a few more populist revolts for them to realize they are wrong about the economy. I find it amazing when I talk to retail investors, who don’t have a full-time job, tell me how great the economy is because stocks are high. This disconnect is powerful, but cannot last much longer. Assets will crash and reality will set in soon enough.

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