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Italy remains a source of tension, but its problems remain localized. We do not see the rejection of the referendum has part of the Brexit-US election axis, and the 40% that voted for the referendum is a sufficient block to elect the next Prime Minister. We would suggest the local elections earlier this year, in which the Five-Star Movement won in Rome and Turin is a more revealing sign of its ascendancy.  

Italy's foreign minister Gentiloni will replace Renzi as Prime Minister provided he can put together a government that can win a confidence vote. A broad coalition government needs to be in place by the middle of the week, to allow Gentiloni to represent Italy at the EU Summit that begins Thursday. Gentiloni is the fourth unelected Italian Prime Minister.

There are three main tasks for the caretaker government: prepare for elections, make the necessary decisions to address the simmering banking crisis, continued reconstruction of the areas devastated by the recent earthquakes.  An election before the Dutch election in March seems optimistic, but still the table is set for quite a political spring in Europe (Holland, Italy and France, UK likely triggering Article 50, before German elections in the Fall).

The Italian premium over Germany has been trending higher all year. It began below 100 bp and is now at 167 bp, having been a little above 185 bp in late November. Italy's 10-year bond yield is up 45 bp this year. Spain's is off 25 bp. However, Italy can still borrow money at negative interest rates going out two years. The current minus nine basis points compares with positive ten basis point in late November. The Italian bank stock index fell 2.25% before the weekend, it still closed higher on the 12.75% on the week and 18% over the past two weeks. Perhaps, if necessary, the interregnum government can take the unpleasant step of seeking ESM support, which could otherwise tarnish Renzi's comeback.

Renzi not Grillo, the head of the 5-Star Movement is likely the odds-on favorite of the next election at this juncture. The Constitutional review of the new electoral law for the lower chamber after the former law were disallowed will take place in late January. If the new electoral law is rejected by the Court on grounds that giving a bonus to the largest party is not consistent with representative government, it would further bolster Renzi insofar as it favors coalition building, and this is a critical weakness for the Five-Star Movement.

Lastly, we note the dollar is running against the yen. It has risen in seven of the past nine weeks. It began with an eight-day advance in late September and early October, well before the US election. After carving out a base in the summer around JPY100, the dollar has rallied strongly. Since the middle of September, the yen has fallen nearly 12% against the dollar. The greenback has retraced a little more than 60% of the decline since peaking in June 2015 near JPY126.  In the coming months, we expect the dollar to works its way back toward JPY120.

Since the middle of September foreign investors have returned to the Japanese stock market. In the last 10 weeks, foreign investors bought an average of JPY258 bln of Japanese equities a week. In these ten weeks, in all bought one saw net foreign buying. The average over the previous 10 weeks was a net sale of JPY249 bln over which time foreigner were net buyers in two of the weeks.  The Topix has rallied about 13% over the period.   

Japan reports the Tankan Survey next week. There is good reason to be optimistic of the Japanese economy in the near-term. Growth in this quarter is off to a better start than the previous quarter. There will be an increase of fiscal stimulus next year. Higher oil prices will aid efforts to arrest lingering deflation pressures.  While the US President-election appears to have ruled out TPP, much to Japan's dismay, his more confrontational approach to China and "American First" plays well for Abe, who continues to expand Japan's military capacity.

Marc Chandler
Global head of currency strategy at BBH
Brown Brothers Harriman

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