Italy Industrial Production and Chaos Theory

Yes, I'm eating spaghetti today for lunch in honor of Italy's second straight month in a row of beating industrial production expectations. A positive trend in this industry will bode well for President Renzi's hope for the passing of his constitutional referendum to pass next week. In August, output rose 1.7 percent, a positive surprise over the -0.1 percent expected. In July, expectations were also beaten with a 0.7 percent jump. Such meager statistics are not trivial, for those who doubt my need for celebration, as any positive growth trend is critical in a world that has been deemed "low growth." This will be especially true for the ailing Italians who have been in perplexing economic and political positions for some time now. Renzi's cut in corporate taxes will hope to rectify business sentiment that has drifted with low growth. GDP of the ninth largest economy in the world has stagnated over the past four years with growth finally positive midway through 2014. But, in June of this year, GDP movement fell flat. So you'd understand why a spaghetti dinner is appropriate, and it might not be the only rejoicing meal either.

The STOXX 600, composed of major European stocks, posted healthy gains of about 0.7 percent today. The Italian stock exchange, with the largest overall increase out od European exchanges, led with gains of 1.38 percent gains. The short-term euphoria helped by good feelings in Italy was mostly caused by new highs in the crude oil market. WTI and Brent prices are both up about 3 percent on the news that Putin might actually cut production. Spaghetti? That news warrants an entire pan of lasagna. ENI's investors are certainly taking a slice as they watch their shares in the largest Italian oil and gas company grow by 2.33 percent. The stock is reversing a month-long downtrend in favor of a five-day gain of over 5 percent. This growth, not particularly driven by technicals, could continue in response to more catalysts, especially if a higher oil price remains in play.

But we didn't come all this way to talk about Italian energy stocks. After all, Total , BP, and Royal Dutch Shell account for most of the sector's movement in European stock indexes. The same could be said about Italy and its economic woes. The world, and really Europe for that matter, should be large enough to make up for weakness in a small branch of its hierarchy. At some level, this kind of compartmentalization helps us diversify and avoid risks that made the 2008 crisis so deadly, systemic risks. Already seen by the Greek example, debt-burdened countries see softer growth and political destabilization both of which lead to recession and financial collapse. These risks and uncertainties are relatively compartmentalized and only send small shockwaves to its closest trade partners. Italy is the next economy under the microscope and many see its weaknesses secular to the domestic system. Instead, analysts prefer to pick apart events like Brexit which appear to pose a larger systemic threat, but the impact may be overstated as the status quo is likely to remain.

Italy's debt to GDP ratio has risen by over 30 percent since the financial crisis struck in 2008 and the beginning of the low-interest rate environment. The proliferation of cheap corporate and sovereign debt bogged down major developed economies like Japan, Ireland, Portugal, and Italy which saw this credit growth as the only way to stimulate growth coming out of the Great Recession. Whether or not that is the case, risks within the economies aren't as compartmentalized like they should be. Instead, this risk has been transferred to the European banking sector. This year, headlines lamenting the performance of financial firms within the eurozone have caused investors to be wary in the bond and equity markets. The STOXX Europe Banks index is down over 25 percent year-to-date. But why have I jumped from an Italian debt crisis to weak European banks?

In chaos theory, the butterfly effect is summarized by the quote: "It has been said that something as small as the flutter of a butterfly's wing can ultimately cause a typhoon halfway across the world." The incredulity of such a claim is only overshadowed by the monstrosity of a chaotic system. In these systems, the initial condition means everything as a tiny tweak in that condition could translate to an amplified effect later on down the road. Financial systems are no different with millions of minds and trillions of dollars connected by a web, not unlike the spaghetti I eat. Economists and financial analysts can worry about macroeconomic events like Brexit and a shifting price of oil and make decent observations about the economy, but in chaotic systems, this analysis is often not good enough. And that's often the problem with financial interconnectedness, there are too many factors to begin with.

Recently, the weaknesses of Deutsche Bank and other European banks have been in the spotlight. Their profitability has run low and negative bond yields ultimately threaten the profit margins of the financial institutions that rely on them for safe assets. As a result, these institutions have fled to higher yield securities like corporate bonds and risky sovereign bonds. The web has been strung. Now these banks have left themselves exposed to riskier underlying assets in an environment where equity valuations are high and government debt is growing (especially in those countries with higher sovereign bond yields). The bank stocks may have supported their bottom line, but implicitly, their assets make it riskier. Although, this isn't exactly clear to the plain vanilla investor. In June, the IMF released a report on a stress test of the German financial sector. The analysis revealed that Deutsche Bank has heavy exposure in the sovereign bond market, and later on, the same paper suggested that the bank is one of the most "systemically important" institutions with regards to interconnectedness.

Through that channel, a weak Italy could explode into something bigger, helped by the size and complexity of Deutsche Bank's dealings. I do not suggest that a slow Italy will break the system, but by the tenets of chaos theory, lower sovereign bond valuations will create a weaker DB portfolio. Questions regarding the bank's financial health are systemically dangerous (as indicated by the IMF). So yes, celebrating a minor recovery in Italy is warranted. Similar celebrations would be appropriate for improvements in Portugal, Ireland, and Greece, all countries which, domestically, show compartmentalized weakness, but are often not considered to be a systemic threat. But, it is important to acknowledge chaos theory and recognize that even the smallest change can be relevant. If you're still unconvinced, rewind to 2008 and observe what a small increase in mortgage defaults


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