The equity markets may be muted today but there's dancing in the streets of Italy as the troubled nation celebrates the resignation of widely reviled Prime Minister Silvio Berlusconi. The incoming PM is Mario Monti, a former European commissioner who is perhaps most familiar to Americans as the man who squashed General Electric's (GE) attempt to acquire Honeywell (HON) and fined Microsoft (MSFT) over half a billion dollars.
As is generally the case, the question on U.S. investors' minds is: Why do I care, what does this mean to me? To help find an answer Breakout welcomed Ed Dempsey, founder and CIO of Pension Partners.
Dempsey says item #1 on Monti's agenda is an implementation of belt-tightening. "It appears he has an austerity mandate from the people," notes Dempsey. While it may be the first time in history a populous has celebrated a cutback in their own quality of living, austerity is needed to assuage bond market fears that Italy will be the next to fall in Europe.
The easiest way to see this drop in confidence is the yield on Italy's 10-year debt. At one point last week Italy had to pay investors over 7% to take the country's debt. As a comparison, the U.S. 10-year yield is a hair over 2% and France, thought by many to be next in line should Italy fail, is currently just under 3.5%. The higher the yield the harder it is for a country to service its debt, and 7% approaches nosebleed levels.
Keeping an eye on the market for Italian and French 10-year treasuries may be too wonky for most U.S. stock investors but Dempsey says debt markets are key to the next move in equities. "It's all about Italy right here," says Dempsey. Italian debt yields are at "pressure cooker levels" and Dempsey notes that the amount of time between a Eurozone member's debt going over over 7% and when that country needs to go hat-in-hand to the IMF has been 27 days. There isn't enough money currently available to bail out the 3rd largest economy in Europe should Italy fail, suggesting a 6-handle on the Italian yield is critical.
Dempsey says the equity melt-up is frozen, albeit in a range more volatile than even 2008, until the debt market decides it has confidence in Italy and drives yields back under 6%. If that doesn't happen, Italy's cost of money will be too high to fund a recovery; meaning France fails and the Eurozone effectively dies. On the happy side of life, if the "yield fever breaks" we're back to Dempsey's year-end equity melt-up idea and the market will rally on.
Regardless of how sick you are of reading about Europe, and how tiresome it is to write about it, U.S. investors need to pay attention. Like it or not, what happens in Italy likely dictates the next big move in U.S. equity markets. For what it may be worth, as I type the yield on the Italian 10-year is precisely 6.66%; a spooky number even two weeks after Halloween.
Are you paying attention to the day-to-day developments out of Europe? Or has crisis fatigue gotten the best of you? Let us know in the comment section below.