As absurd as it might seem to investors in global bond funds, risk in bonds issued by some of the 19 members of the eurozone may, quite soon, become among the scariest in the world.
This is the year the populists began shaking up North Atlantic capital markets.
All investment managers heard about the populists in Britain and the eurozone, and they certainly heard a lot from Donald Trump. But how many bond managers built populism into their portfolio planning? As Mike Tyson, former professional heavyweight boxer, noted: “Everyone has a plan until they are hit in the mouth.”
British voters rejected the elites' advice and threats and followed populists' exhortations to vote to leave the European Union. How dare they doubt Davos! The pound took a pounding, and holders of gilts who secretly thought Brexit might succeed were consumed with guilt.
Mr. Trump, an unlikely populist, is causing more headaches for the politically correct, and liberals in general, than all the 16 other Republican candidates who stood up for the first debate in 2015 combined. He has been bad news for bond investors because of his grandiose infrastructure plans, but good news for equity investors who see this stimulus coming in time to prevent a recession.
Next in line for populist shocks is the eurozone. Its first crisis really began with Italy's Dec. 4 referendum vote on amending its constitution. That complex document, designed to ensure no fascist or communist dictator could take charge, has had the effect of delivering new presidents almost annually. The result is a multiplicity of parties and backroom deals and corruption and, in the south, heavy participation from organized crime. An exasperated Prime Minister Matteo Renzi, possessed of unusual charm and magnetism, asked voters to redo the constitution to take away power from the senate. Italy is the third largest economy in the eurozone and has been — by a wide margin — the poorest performer among the heavyweights.
The referendum was voted down by an overwhelming margin, and Mr. Renzi resigned. No one is sure what happens next, but most people suspect it will be as always — more of the same, with less economic growth than its neighbors and more debt per capita than almost any nation.
Or maybe not. What is new is that leaders in many of the other Italian parties are calling for a Brexit-style referendum on continued participation in the eurozone. If that referendum were to succeed, Italy would secede from the eurozone while remaining within the European Union. The nation would return to the lira.
Italy is more important to global debt markets than its economic scale would suggest. It has the world's fifth-largest government-funded debt, but is merely the ninth-largest economy. Because Italian GDP would be counted in liras, and Italian debt would no longer be backed by the European Central Bank, those bonds would, at the very least, be significantly devalued and would surely underperform most other industrial nation bonds for years.
At particular risk are all those Italian zero-coupon bonds issued at discounts to par. What would a negative-yield bond with no ECB backing be worth? Doubtless more than a losing lottery ticket, but how much more would depend on whether a new Italian government were to respond to “Italexit” with the kind of tough reforms Spain introduced and enforced. Those reforms triggered widespread pain, but have made Spain's recent economic performance one of the strongest in the eurozone.
So where would the pain of “Italexit” be felt?
The European Central Bank, Italian banks and eurozone member banks hold humongous levels of Italian bonds. Italian banks already were in crisis before this referendum was called, but in recent weeks their stock prices have plunged precipitously. After a desperation attempt to save it, Italy's oldest bank's share price is a fraction of a euro. It has seen some tough times and survived: It was formed two decades before an Italian sailor talked a Spanish monarch into backing his idea to find Asia by sailing west.
The ECB pledged to support the euro and Italian bonds no matter the referendum outcome. It did a great job after the vote announcement supporting the euro and maintaining an orderly bond market. Within minutes after announcement of polls showing defeat, the euro fell and gold climbed $10 an ounce. But by the time U.S. markets opened, gold was actually down $5 an ounce, and the euro was up a full cent against the dollar.
The ECB had been buying eurobonds at the rate of e80 billion a month, and there will be real concerns from the Germans and other members about excessive support for Italy. Given Italy's weight in global bond funds and exchange-traded funds plus the dire state of Italian banks, any euro crisis would hit Italian assets particularly hard.
Bond investors will not have to wait long for some more excitement.
The Italian crisis is merely one part of a euro-crisis that includes vast numbers of refugees, terrorist attacks and crumbling governments.
Brexit helped to beget Trumpism, and Trumpism has been an elixir for radical politicians in eurozone nations. Champagne corks were popped in Paris when Mr. Trump's victory was announced. Marine Le Pen, the leader of the radical National Front party in France, announced that if her party wins the upcoming elections in that country, she will call for a referendum to pull France out of the eurozone. In normally placid Holland, Geert Wilders, leader of the Party for Freedom, is trying for a “Duxit” vote.
Henry Kissinger said the European Union was a great concept — uniting Europe after the centuries of wars. However, he warned, the EU must never impose a single currency. Why? Because a free-trade zone that includes well-run nations with strong finances and sound banks backed by highly competitive businesses that compete with nations with fragile political leaderships backed by uncompetitive economies and weak banks would prove disastrous.
At 93, Mr. Kissinger has lived to see his grim forecast unfolding.
Joseph E. Stiglitz, professor at Columbia University and 2001 winner of the Nobel Memorial Prize in Economic Sciences, speaking Nov. 30 about the euro at the Chicago Council on Global Affairs, was very pessimistic on the eurozone but surprisingly optimistic on Britain after Brexit. Why? Because the pound's value has fallen more than 15%. Under the General Agreement on Tariffs and Trade, which governs international trade outside specific deals, tariffs are generally limited to 5%, so British exports should be more competitive in the future than they were prior to the approval of Brexit.
Referring to the other potential referendums, Mr. Stiglitz said the eurozone banking system is already very weak and these populist campaigns could imperil the entire European experience.
Cautious global bond fund managers might well choose to avoid being the last to exit from bonds from those nations — led by Italy — that could be voting to scrap participation in the euro. Even if all the votes failed, pressure on the relative valuation of those nations' bonds is bound to be abnormally high for as long as it takes to defuse the fears and passions of populism.
