The Italian drama is more smoke than fire

Outlook:

The schedule of releases today is huge, including industrial production, JOLTS and the Treasury Capital report. We guess that JOLTS will get the most notice, because we have been seeing an increasing number of people confident that if they leave their jobs voluntarily, they have found or can find a new one. This is an excellent proxy for consumer confidence as well as various employment and wage growth statistics.

As for the August TICS report, we see no reason for inflows to moderate now that we are getting some, if only a trickle, of tax repatriation. July had an inflow of $95.6 billion in July, almost double the amount the year before. This more than offsets the Goldman thesis above that the US could be losing its reserve currency status.

Then there is the Italian drama. The FT reports Italy delivered its new budget at midnight overnight and now Brussels has a week to crunch its numbers. It has “a fortnight to let the Italians know if the budget doesn’t pass muster.” Semantics matter. The key phrase will be "significant deviation" from expected norms, if that’s what Brussels determines, Italy will have until end-October to submit a new version. The FT reports Barclays estimates the EU growth rate of 1.1% means the deficit will be more like 3% than Rome’s 2.4%. Italy claims its initiatives will boost growth. See the chart.

Italian leaders have signaled they will not retreat, meaning the "excessive deficit procedure" comes next, including sanctions, but not until next spring. The FT concludes “Conte will probably relish the fight – provoking the kind of headline-grabbing clash that plays well with supporters of the governing League and Five Star coalition. Watch this space.”

All of this sounds awful and perhaps like Grexit, but in practice, when we know what to expect and when to expect it, it’s a dud as a market-mover. It’s surprises and shocks that upset markets, including FX. We are starting to smell that the Italian drama is more smoke than fire. If the FX market comes to accept that point of view, the euro gets a monkey off its back. In other words, traders are already pricing in some drama but nothing truly disruptive. After all, nobody can forecast GDP all that well.

The pricing-in phenomenon is also what is behind the dollar’s slump. All the good news is known—tax cuts, Fed hikes, even the stock market pullback—leaving the dollar stranded without new factors. Jolts today might be nice, but the market is waiting for some bigger variables to kick in. The problem with the waiting game in FX is that some folks invent factors out of whole cloth. Gold, for example, or oil, or another Trump-inspired outrage of some sort. The Saudi situation will probably come and go while Trump devises some new distraction to appeal to the base and get them out to vote on Nov 6. Maybe pushing up the date of the Chinese tariff hike to 25% from year-end to now. We can hardly expect peace and quiet from Washington until Nov 6. Gird your loins. Something is coming.

More about the stock market: Seekingalpha writer Eric Parnell wrote yesterday that small and medium caps, and international and EM names, might be over, but not the Big Kahuna, the S&P. He sees the correction persisting for a while but the rally resuming at some point before year-end, for four reasons: first is technical support at the 400-day moving average. Harumph. But wait, he says for the bull market to be over, the S&P would have to hit the 400, rise back up to the 200, and then fail to hold the 200. This is actually a not bad test.

Second, volatility is not accumulating like it did in the tech bubble in 2000, let alone the pullback in 2007. Third is “credit stress,” defined as high bond spreads. He uses something named the ICE BoAML Master II Option Adjusted Spread, and indeed it spiked ahead of other big corrections and not this time. 

Finally, there is fear of missing out, aka greed. Those who missed out the first time are happy to bottom-fish. Here comes the wisdom: “Now it is very possible that the current correction could be the beginning of the end. But even if it is, stock markets simply do not go down in a straight line. Instead, sharp declines are followed by equally swift rallies to the upside as it oscillates is way lower.”

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