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The EU’s Games of Chicken Are Coming Home to Roost

The EU’s Games of Chicken Are Coming Home to Roost

Friday, 16 November, 2018 - 15:30
The classic movie “Rebel Without A Cause” starring James Dean provided a great model for negotiations. In one memorable scene, Dean’s character and a rival raced their car toward a cliff in a sort of competition to see who was braver. The winner was the last to swerve; the loser swerved first, and therefore was a “chicken.” But to win, one had to face the risk of disaster. In the movie, our hero survives, while his rival gets his sleeve caught in the door and he is unable to escape or swerve in time. His car plunges over the cliff.

The European Union is playing a game of chicken with two of its biggest and most powerful members: the UK and Italy. The UK, which has voted to leave the EU, is trying hard to negotiate a deal to leave and playing very tough. If it fails, there is a real risk of an exit without a compromise, which would suddenly entail needing to renegotiate 759 treaties with 168 different countries.

This game of chicken involves not only the UK and the EU, but also multiple factions within the UK. Ministers have resigned from Prime Minister Theresa May’s cabinet both because they wanted a tougher approach to leaving, as was the case with former foreign secretary Boris Johnson, and also because they opposed the entire undertaking and wanted the whole matter put to a referendum, as led Jo Johnson, Boris’ younger brother.

The problem the competing parties face is that virtually any option that seems viable at this point would be demonstrably worse than the status quo, surrendering the U.K.’s vote within the EU while still being subject to at least some of its rules. But the leaders of both the government and the opposition have ruled out putting the whole matter to another referendum. Thus, without an agreement on any one proposal, a “no-deal” exit, or Brexit, becomes likely.

It is possible that the dangers of a “no-deal” exit are being overstated. There are concerns over whether jets could even leave Heathrow airport, while plans are in motion to stockpile medicine and food ahead of what could become much longer supply bottlenecks. The fact that it is possible to question how bad a “no-deal” would be (Brexit supporters accurately assert that the U.K. got on fine for centuries on its own before joining the EU) greatly increases the risk that nobody swerves, and the U.K. goes over the cliff.

Then there is Italy. It has set a budget that involves a far greater deficit and far greater fiscal expansion than is permitted under the 1991 Maastricht Treaty that set the terms for countries to join the euro. Last month, the EU formally rejected the budget. This seems necessary. Without maintaining discipline, other countries will follow Italy’s lead and the euro will lose all credibility. After the force that the EU applied to minnows such as Portugal, Greece and Cyprus to adopt extreme austerity in return for avoiding a departure form the euro, it would seem that there is little choice but to force Italy into a new budget.

But the Italian government does not see it that way. And the EU has a problem because the bond market is not helping. As judged by the spread of Italian sovereign bond yields over comparable German bunds, bond traders regarded the alarming election result in Italy with total complacency. Yields shot up in late May as it suddenly became apparent that the right-populist Lega and left-populist Five-Star movement might be able to work together to the detriment of bond traders. They shot up again as the confrontation with the EU took shape, but they have been stable for several weeks now.

Yield spreads at these levels are difficult for Italy, but survivable. The government has previously said the spread should not go through 4 percentage points. It remains safely below that level, appearing to embolden Italy. Matteo Salvini, Italy’s deputy prime minister, told reporters on Monday, “The budget doesn’t change because the EU sends us letters.”

Italy is also aided by the stock and the currency markets. The euro is falling, making it harder for the EU to risk an all-out confrontation. And bank stocks are in serious trouble, again making it harder to take action against Italy.

Of the two games of chicken, the disaster scenario in the case of Italy would be much worse than with UK. It would mean the dissolution of the euro, an event for which there is no precedent, and would affect every economy in the world. It is hard to see how a “no-deal” Brexit for a country that is not part of the euro could be as bad as this, beyond British shores.

But the chances of a plunge over the side of a cliff is far greater for the UK than for Italy. The EU is highly unlikely to swerve in its game with the UK. Italy is a different matter.

US stocks suffered another brutal sell-off Monday. There were plenty of reasons for the decline, but this leg of the correction looks like a fundamentally driven attempt to address the overvaluation of the “FAANG” group stocks (the acronym Facebook,, Apple, Netflix and Google), and a new affection for under-appreciated and less cyclical defensive stocks. As I commented last month when Procter & Gamble enjoyed its best day in years, when people get excited about sales of toothpaste and toilet-cleaner, it tends to suggest something rather bad about their sentiment toward the market broadly. Now my Bloomberg News colleague Luke Kawa has taken the exercise a step further by comparing P&G’s valuation via its price-to-earnings multiple with that of the tech-heavy Nasdaq-100.

At this point, investors are prepared to pay more for the predictable earnings growth in basic consumer products than they will pay for all the growth potential in Apple, and the other stalwarts of the Nasdaq. This is an unusual state of affairs. As the chart shows, the gap between P&G’s valuation and that of the Nasdaq grew extreme earlier this year, and it is unusual for investors to pay a premium for P&G for any length of time. So we can see that this has been an extreme rotation within the market.

After Monday’s latest downdraft, it also looks as though the time to buy is either or rapidly approaching. P&G, very unusually, was the best performer in the S&P 500 in terms of index points, accounting for 0.19 extra point. Unfortunately, Apple’s decline accounted for a reduction of 5.11 S&P 500 index points. Investors are enthusiastically hunting the stocks that have been caught on the other side of the “FAANG trade” and invested in companies that had sold off too much on concern that and the others would eat away their profits. We are now seeing a full-blown reaction.
For another illustration, try this one: the combined market cap of and Apple had briefly exceeded that of the entire S&P 500 Consumer Staples sector, including 32 companies headed by P&G, Coca-Cola, PepsiCo and Walmart.

Looked at this way, regrettably, the message is that the selling has further to go. The rise of the biggest internet players on this basis looks like an aberration, and needs to be corrected further. The way this sell-off follows evidence of problems for iPhone sales and pain for Apple’s biggest suppliers strengthens the evidence that this latest leg of the downturn has more of a basis in fundamentals than those that preceded it. Investors are taking a hard look at exactly what evidence there is for the FAANG’s growth potential, rather belatedly, and adjusting prices accordingly. How long will that process last? It depends where the evidence takes us.


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