Italy Roils Global Markets
Global markets have fallen over the last week in reaction to the political developments in Italy. Initial reports that two Italian populist parties were ready to reach an agreement on a coalition government led to tumult in Italian markets, and greater risk aversion by investors. On May 17th, the Five Star party and the League party came to an understanding to form a ruling coalition. They both believe that budget deficits and debt do not matter and that Italy would be better off without a lot of interference from Brussels. They do not believe the austerity measures implemented by Brussels are necessary or helpful. While they have several key disagreements, both parties appear ambivalent towards the Euro. They seem to think staying may be the best alternative, but neither are they strident supporters of remaining in the Euro like the Italian technocrats. The Italian populace is itself divided over the Euro, while most Italians believe that it would be best to remain a part of the Eurozone.
In response, the Euro has fallen approximately seven percent against the dollar over the past month and a half as global financial markets sniffed out the political risk from Italy and reacted accordingly. The yield on Italian government debt has spiked higher. As of Tuesday, May 29th, the yield on Italian government debt stood at 3.15% compared to just 1.74% on May 3rd according to Bloomberg. Meanwhile German ten-year government debt declined from 0.53% on May 3rd to 0.26% on May 29th, while ten-year U.S. Government debt fell from 2.95% on May 3rd to 2.77% on May 29th according to Bloomberg. The FTSE MIB Index consists of 40 large stocks on the Italian Exchange. It has fallen slightly more than thirteen percent from its May 7th closing high as the political turmoil has weighed on Italian risk assets. In short, Italian and global markets are worried about the chance that Italy could leave the Euro.
Over the weekend, the alliances nominee for finance minister was rejected by the Italian president. The rejection was the result of the nominee’s reputation for being a Euroskeptic. While his views were very much aligned with the ruling alliance, they were too unsettling to the European order for the president who is an elder statesman appointed by a broad group of politicians. This sets up Italy for new elections which will probably be held in September or October. While it’s a clear win in the short run for the Eurozone, it could set up Italy for what would become essentially a referendum on remaining in the single currency. That would come about if the Five Star and the League combine ahead of the election to seek an electoral mandate rather than running as separate parties.
Italy is the third largest economy in the Euro and has a debt-to-GDP ratio that trails only Japan among major countries. As opposed to Greece which is a minor economy and whose problems were a nuisance to the Eurozone, Italy is a more serious issue. Italy is a highly levered, high-cost economy located at the foot of Europe. It’s GDP currently exceeds Russia, even though its geopolitical importance is much smaller. Nevertheless, if Italy, were to the leave the Euro, it would probably spell the end of the Euro as we know it. As such, the short-term downside risk posed by Italy is much more than the risk posed by Greece.
The Eurozone expansion of 2017 was one of the key contributors to a synchronized global expansion, and rising global equity markets. The economy has slowed lately after a strong Euro in 2017 made Europe slightly less competitive. The recent decline in the euro should reverse that trend. However, the recovery is still fragile and any additional risk to the European framework is likely to unsettle markets regardless of whether it effects the economy. The large decline in equity markets today probably discount most of the immediate negative concern surrounding Italy. We believe that markets remain range-bound and don’t see this as start of a larger decline. Still, the news from Italy will remain an overhang for markets until it is resolved.