European markets have shrugged off Italy’s latest political drama
Many of Europe’s leading stock market indices, including Germany’s DAX, have underperformed other global regions over the past six months. Even before Italy’s recent political crisis, the macro signals had waned. The growth rates of industrial production and new factory orders have declined, conditions in the retail sector have weakened, and the demand from businesses for new loans has fallen.
Although we’ve been expecting a slowdown in eurozone growth since the third quarter of 2017, many investors have been caught off guard. Growth expectations were still high and the downbeat data caused Citi’s European Economic Surprise Index to hit a post-crisis low. Earnings per share forecasts have been revised down and may need to fall further. Political turmoil has soured sentiment further.
However, we don’t believe Italy’s political and fiscal problems will develop into another regional debt crisis. The architecture of Europe’s economic union is very different today than in 2011. Numerous backstops have been implemented for countries that agree to play by the rules, including the European Central Bank’s ability to buy unlimited amounts of government bonds.
The yield gap
These measures appear to be working — Spanish and Portuguese bonds suffered little disruption from the political turmoil, and 10-year yields on the latter remained 50 basis points less than US Treasuries. Even the spread in yields on Italian government bonds over German Bunds came nowhere near the wide gap reached during the 2011 eurozone debt crisis (figure 3).
Meanwhile, high-yield corporate debt yields stayed at a third of their 2011 levels and credit default swaps (a measure of credit risk) remained relatively cheap. Although European bank share prices have reached a new low relative to their American counterparts, the average yield on BBB-rated bonds issued by financial companies is 2.75% compared with 25% during the crisis.
Figure 3: Not another sovereign debt crisis
Italian government bond yields spiked recently, as did the spread over German bund yields, as the country suffered a period of political uncertainty.
Source: Datastream and Rathbones.
A populist government
Italians are fed up with austerity, which they blame for the country’s economic malaise, and their populist politicians have pandered to them. Following an uncertain election result and 88 days of political impasse, Italy got a new government at the beginning of June.
It is in reality an uneasy coalition formed from the populist left-wing Five Star Movement and the nationalist Northern League. Promises of both tax cuts and benefit increases could rapidly clash with the EU’s budget rules. Yet both parties have backed away from previous calls to leave the EU.
Although the amount that Italy’s government takes in taxes is more than it pays out (excluding interest payments), a fiscal splurge of the magnitude planned by the new coalition could soon become unsustainable. Meanwhile, the country’s greatest problems remain — woeful productivity, one of Europe’s most rapidly ageing workforces, and a banking system still drowning in bad loans.
Italy’s economic outlook is bleak. No party has the political capital to push for sorely needed reform. The country has a small graduate population, a highly unionised workforce, terrible social benefits and a form of proportional representation — all attributes that increase the tendency for populism to take hold.
Italy’s political environment is likely to produce negative news stories, driving market volatility higher and risk-adjusted returns lower.
Although the political and economic situation in Spain is also fragile, the party in the ascendancy is the firmly pro-EU, pro-reform Ciudadanos, which has seemingly radical but actually centrist ideas. Yet, Spanish banks have lent a lot of money to Italian borrowers. We are taking nothing for granted. We don’t see Italy’s problems morphing into another regional debt crisis. But during periods of stress, it will be important to focus on the wider picture and ask if the contagion is spreading to other countries.