Italy….the Elephant in the Room

Last week, the S&P500 gave back about 2.5% in another volatile trading period. The VIX index jumped up 23%, yet volume was moderate.  The upward momentum, that was created in the strong October bounce, seemed to weaken.  Market breadth in the bounce also weakened; the number of stocks setting net new highs declined.

On the economic front, there were quite a few releases.  Chicago PMI met expectations.  ISM manufacturing missed expectations; even more critically, ISM services also missed.  Since the ISM reports are some of the most important leading indicators of economic growth, these two misses paint a bleak picture of the economy, suggesting that a recession is now more likely. Initial jobless claims were slightly better than expected, as were factory orders.  The big number of the week—the October jobs report—missed.  Only 80,000 jobs were created vs. the 90,000 that were expected. What’s worse is that the BLS’s (Bureau of Labor Statistics) birth/death model added a mythical 103,000 jobs, so that eliminating these fictitious jobs (even after adjusting for seasonality) means that the TRUE jobs picture was far more bleak—jobs were actually LOST in October.

The major catalyst of last week’s roller coaster ride in risk markets was Greece and its internal struggle to impose austerity onto its own citizens, austerity designed to bail out the European banks that lent money to Greece.

Risk markets reacted to the possibility that Greece may not succeed in condemning its citizens to decades of harsh austerity, especially if they were to be given a chance to vote on it directly.

In the meantime, a monstrously greater threat has been growing in Euroland—Italy.  This distinguished member of the PIIGS has managed to rack up over $2.5 trillion in sovereign debt, more debt than in any other state in the Eurozone or in the European Union.  In fact, Italy has so much sovereign debt that only two nations in the WORLD have more—the US and Japan.

Over the last two years, the difference between what Italy pays on its debt and the rate that Germany pays on its debt (the spread) has been widening steadily.  The spread is a measure of the credit risk of the nation with the higher yielding debt. In this case, Italy’s spread has blown out to over 4.5 percentage points over the comparable German debt.

And that’s a problem.  The credit markets are now saying that Italy’s debt is far from risk free.  And this widening of the spread is exactly what happened to Greece, Ireland and Portugal before all three required bailouts.

The problem, more specifically, is that unlike the other three PIIGS, Italy’s massive debt load is too large to be credibly backstopped by, well, anyone in the world—the rest of the Eurozone, the EU, the IMF, the US, and China.

And while equity (and other risk markets) have been busy “bouncing” over the last four weeks, Italy’s debt problem—the elephant in the room—has been getting progressively worse.

Many economic experts are sounding the alarm, namely that Italy is fast approaching a tipping point, one that would almost certainly tip not only the Eurozone into an economic and financial crisis, but most likely the rest of the world as well.

And unless the ECB suddenly changes colors and decides to print hundreds of billions of euros (with which to buy up hundreds of billions of Italian debt), then the chances we’ll see such a disaster are getting to be uncomfortably high.

So while all eyes are on Greece, we really ought to be preparing for the much more devastating threat that ‘s brewing in Silvio Berlusconi’s back yard.

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