Fundamental flaws

Rule Number One in the art of making money in markets is simple; it’s about getting to where the market is going before the market gets there.

Rule Number Two is just as easy; in the end, the fundamentals will always prevail. So much for the wise man in a wing-back chair smoking a pipe and philosophising about how it is… or maybe how it was.

All this is rolled over by the appreciation that firstly if you don’t know where you’re going, you don’t know when you’re lost and secondly, the level of intervention in and manipulation of the economy by the authorities, especially the central banks, is now of such a magnitude that nobody has the faintest clue any longer what the fundamentals would actually look like, even if they hit them in the face.

Ask me not what has become of the free market for goods and services or what kind of behind the scenes manipulation we have to tolerate in order to maintain the fiction of one existing.

It is about two years ago that I looked at the collapse of the Italian bond market, compared it with the Spanish one and concluded that there was no rational reason for the latter to be trading better than the former. I then wrote the piece in which I coined the phrase that Spain has a first class government presiding over not much by way of an economy as opposed to Italy which sported a fantastic industrial economy presided over by idiots. Thus, I surmised that Italy could, under the right leadership, dig deep and get itself sorted whereas poor old Spain really had nowhere to go. On that basis, Italy had to be a screaming buy over Spain.

Fences

In the event, anyone who would have followed my suggestion would have made out like a bandit over a six month horizon, had they not already been fired for putting on a horrendously costly position at the recent year-end. I made the call in October when 10yr Italian BTPs were trading around 100bp cheap to Spanish Bonos. The Italian market continued its collapse through year-end when the spread closed at 200bp in favour of Spain. However, in November 2011, Mario Monti had been called upon to create his famed technocratic government; by March 2012, Spain and Italy were flat and more or less by midyear Italy was trading 100bp rich to Spain.

Since the Italian parliamentary elections in February of this year which engineered the ousting of Professor Monti, BTPs have dribbled lower and once again the two markets are flat to one another. In fact, apart from a few basis points here and there, they are more or less flat across the entire yield curve. Given the original tenets of my analysis two years ago, how can this be? What, if anything, has changed?

I decided to call on a friends – apparently I still have some – in order to gather some opinions as to whether the time might be right at these levels to again sell Spain against Italy as a strategic trade. My word, if there were a World Cup in sitting on fences, I could quickly assemble a winning team. The overriding opinion was “Don’t ask me, I haven’t got a clue what to do either….” but the one which struck most fear into my heart came from a strategist who asked me whether I might know how much government debt the two respective banking systems had on their books and therefore how much they could still take.

Knowing where the banks put all the government debt once they have bought it (which is into the ECB as collateral), I am effectively being told that it is the European Central Bank which determines where Spain trades to Italy. Ask me not what has become of the free market for goods and services or what kind of behind the scenes manipulation we have to tolerate in order to maintain the fiction of one existing.

Over the past couple of days I have spoken to both a Greek chum and to a German, the latter being a friend who has nothing at all to do with markets and who happened to be in London for his German employer making a pitch for a €1bn long-term software systems maintenance contract to another German company. Between them, they represent the two poles in the eurozone and both of them appeared to feel that the centrifugal forces within the single currency area have not really abated, that grass-root resistance is waxing rather than waning.

In the past years, St Mario has made a pretty good fist of suppressing many of those forces but the question remains open as to how long it can be maintained and, were intervention to be scaled back, whether and in what form they would re-emerge. Until then, we won’t really know what the fundamentals which are supposed to determine where markets go. Hence, I’m afraid, as far as Spain versus Italy is concerned, I will have to join all my friends on that uncomfortable fence… and I’m not happy.