Rome Burns; Europe Can’t Help

One of my favorite countries to visit, Italy, is in big trouble.

Just a few years ago, Italy’s government debt was roughly equal to its gross domestic product (GDP)—it had a debt-to-GDP ratio of about 100%. This is high, but Italy was able to maintain a budget surplus, which means after the bills were paid for the year, there was money left over from taxes the government took in to pay down government debt.

Like a household, the problem with holding high debt levels is that if something goes wrong, it can place the household in serious financial difficulties.

Enter the eurozone financial crisis and Italy’s government debt has now reached a debt-to-GDP level in excess of 120%!

To give some perspective to the problem, remember that the eurozone has been consumed by the problems of Greece, but Greece has government debt of 350 billion euros, while Italy carries government debt of 1.9 trillion euros!

With Italy’s economy in a recession and the unemployment rate at a decade high, this is making its budget targets almost impossible to hit. The prime minister has instituted spending cuts to offset the decline in tax revenue, but the economy continues to contract.

The bond market has attacked Italy, sending its 10-year government debt interest rate above six percent, when two years ago it just was four percent!

Moody’s Investor Services has also downgraded Italy’s government debt to just two levels above junk status, which further puts pressure on interest rates.

While Italy can say it has still been able to maintain a budget surplus despite the eurozone financial crisis, this surplus does not include the interest payments on its government debt.

For example, this month, Italy sold three-year government debt of 5.25 billion euros at an interest rate of 5.6%. Just three months ago, it was able to sell its three-year government debt for 4.3%.

Due to the eurozone debt crisis and the downgrade by Moody’s, how did this affect Italy? Well, 5.25 billion euros at an interest rate of 5.6% means Italy must pay bondholders of its government debt 68.25 million euros more per year for the next three years than if the country was able to issue the government debt at an interest rate of 4.3% (like it used to only 90 days ago)!

And that is just one example. It is estimated that Italy must roll over almost 310 billion euros of its 1.9 trillion euros in government debt in the next 12 months!

So, while interest costs go up dramatically, this will create budget deficits. Lower tax revenues will persist due to the weakening economy, the eurozone crisis, and a continued rise in unemployment. Should the prime minister institute more cuts in a recession—the austerity measure demanded by the eurozone—this will only exacerbate the budget deficit further.

Another vicious circle, which will lead to the bond market demanding higher rates, which will lead to higher interest costs, and on and on.

The eurozone crisis is worsening, dear reader. Just because it is not making headlines right now does not mean it will not be back very, very soon. Greece is a problem, but there is no way the countries of the eurozone can handle the government debts of both Spain and Italy: their government debts are just too large.

What does all this mean for us here in North America? The crisis in Europe results in softer sales for the big companies that make up the S&P 500 stock index—40% of those companies have exposure to Europe.

China is affected because Europe is China’s biggest export market (see: “Chinese Economy Contracting Much Quicker Than Originally Thought”). As the Chinese economy softens, it affects North America in a variety of ways. Bottom line: we are progressively moving deeper into a global recession.

Where the Market Stands; Where it’s Headed:

We are in Phase II of a long-term secular bear market in stocks. Phase II is usually referred to as the “bounce” or “sucker’s rally.” After the initial Phase I take-down, Phase II of a bear market rally gives investors the false sense the economy is improving and the stock market is a safe place to invest again—this is exactly where we are today.

Phase II of the secular bear market started in March of 2009. We are nearing its end. Phase III of the bear market, the next phase, will bring stocks sharply lower.

What He Said:

“When property prices start coming down in North America, it won’t be a pretty sight, because consumers are too leveraged. When consumers have over-borrowed so much that they have no more room in their credit lines to borrow more, when institutions start to get tight on lending, demand for housing will decline and so will prices. It’s only a matter of logic, reality and time.” Michael Lombardi in Profit Confidential, June 23, 2005. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.