investment insights

    Arrivederci? Question marks over Italy’s new government

    Arrivederci? Question marks over Italy’s new government
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Italy’s political turmoil, which hasn’t gone away with a new government, has created the third euro-related crisis in less than a decade. Will the country remain a Eurozone member and make good on election pledges to spend its way out of economic stagnation? These still-open questions have driven Italy’s benchmark government bond yields higher and the euro lower as investors assess the odds.

    Negotiations between the anti-establishment Five Star Movement (M5S) and the right-wing La Lega to create a new government were finally resolved this week after nearly three months of talks. The coalition had threatened new elections after President Sergio Mattarella vetoed the coalition’s first choice for finance minister, the 81-year old Paolo Savona who has advocated leaving the euro. Mr Savona has now been given responsibility for European affairs and Giuseppe Conte, an academic with no political experience, will be prime minister. The two parties’ leaders will both become deputy prime ministers.

    “We will work intensely to realise our political objectives which we have already put together in our government contract,” Mr Conte said, according to Reuters.

    The coalition’s common contract includes a universal minimum wage, corporate and personal tax overhaul, and undoing 2011’s increased retirement age. The programme may cost the country as much as 126 billion euros, equivalent to more than 7% of nominal GDP, based on the International Monetary Fund’s 2018 forecast. The European Union’s ‘fiscal compact’ commits Italy to cutting its debt-to-GDP (gross domestic product) ratio of 132%.

    Friction ahead

    The yield on the Italian 10-year sovereign bond reached 3.164% on 29 May after Mr Mattarella’s veto, and has now retreated to around 2.6% on news of the coalition deal. The spread between Italian government 10-year bonds and German sovereign debt narrowed to 219 basis points, from a May 30 high of 269 basis points.

    The relationship between Italy’s coalition government and the European Union will be turbulent. The coalition will inevitably clash with its European neighbours over its anti-immigration rhetoric and a common goal to scrap the EU’s sanctions on Russia. It has already complained of insults from European Commission officials. The danger is that La Lega and M5S may come to depend on that tension with the EU to maintain their continued cooperation.

    The crisis also has wider implications outside the Eurozone. The EU appears more determined to make Brexit as painful as possible for the UK, so as to spell out the costs of leaving the bloc to Italy’s election winners.

    An institutional crisis

    It’s tempting to look at recent Eurozone economic history for guidance. But unlike 2011 and 2012, we aren’t living through a sovereign solvency crisis. That crisis was resolved through lower interest rates and cheap loans while four of the currency area’s economies were running deficits and risked default.

    Today’s crisis isn’t about fundamentals in Italy nor among the nations sharing the common currency. Debt levels in the Eurozone have stabilized, there are current account surpluses in place. Italy’s debt profile remains sustainable with rather long maturities, while GDP is forecast to rise and unemployment to fall. Italy is also helped by its primary surplus (tax income is higher than spending excluding interest on debt). Italy’s political turmoil combined with softer Eurozone data mean that markets anticipate continued low interest rates on the expectation that monetary policy normalisation will be pushed back.

    What’s rightly scaring investors is that the combination of long-term economic stagnation and political instability is posing an institutional challenge that will be used by the left and right in Italy to fuel further populism, undermining the liberal democratic assumptions of European integration.

    ‘Look, no hands’

    Market angst is intensified by the knowledge that this time the European Central Bank can’t offer a safety net, either technically nor politically. The European scepticism of the newly-formed Italian government rules out asking the ECB for help. Nor can the ECB lower rates or throw its timetable to end quantitative easing into a U-turn.

    We know that markets have a tendency to discount the politically unlikely, and therefore difficult-to-price. When the politically unlikely then comes about, markets tend to overreact.

    In the light of the limited but impossible-to-rule-out risk that Italy does leave the euro, we have reduced our exposure to longer-dated Italian paper until the situation is clearer.

    Italian banks, which hold meaningful quantities of Italian sovereign debt, are directly impacted by widening spreads because it affects their capital and potentially their funding costs (as well as increasing the cost of equity and so their valuations.) Political turmoil and potential changes in policies may also call into question the efforts made by the banks to bring down their non-performing loans as NPL buyers may demand a higher return.

    Investors should continue to watch developments carefully and position themselves cautiously to manage risks and limit exposure as the situation continues to evolve.

    Key takeaways

    • Another Eurozone crisis this time poses the bloc with an institutional challenge
    • Unlike previous euro crises, this one isn’t about Italy’s economic fundamentals
    • The ECB isn’t in a position to help, for political and technical reasons
    • We have reduced our exposure to longer-dated Italian sovereign debt, and are following the impact of higher spreads on Italian banks
    • Investors should watch developments and manage risks cautiously. 

    Wichtige Hinweise.

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