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The Italian crisis - a mere ripple or more of a wave?

The Italian crisis - a mere ripple or more of a wave?

07-06-2018 | 月次アウトルック

It pushed aside trade war talk and the Korean summit saga to take center stage. What started out in Italy as a ripple in March began to take on tsunami-like proportions last week.

  • Peter van der Welle
    Peter
    van der Welle
    Strategist
  • Léon  Cornelissen
    Léon
    Cornelissen
    Chief Economist

Ripples and waves. According to Robeco Investment Solutions, that’s what it all boils down to when making an investment decision: determining whether events will just temporarily disturb the surface of the financial markets or have a major longer-term impact. Whether this becomes a wave or not ultimately depends on whether this unlikely new government can remain intact; something which does not look very likely, right now.

Speed read

  • Muted response to Italian elections back in March
  • Unlikely populist coalition spooks the markets in late May
  • Italy’s strategic role in EU means the stakes are high for Europe

This crisis was slow in coming. Financial markets initially responded to the Italian parliamentary elections as a non-event. Yes, the outcome was disappointing, with populists at both ends of the spectrum gaining more votes than expected, but the fall-out was minimal. Post-election, the Italian 10-year government bond spread widened by a minuscule 4 basis points versus German Bunds, while Italian stocks lost just 0.3%. It was hardly earth-shattering; a mere ripple in fact. And the losses were quickly erased in the weeks that followed, with Italian bonds and stocks actually outperforming the broader Eurozone.

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Spot the panic following the Italian elections…

Source: Bloomberg & Robeco

But things suddenly took a turn for the worse at the end of May, when it became clear that, against all the odds, negotiations between the Five Star Movement and the Lega – the election’s two big winners – might actually be moving towards a successful conclusion. The political differences between these two parties are all too obvious; figuring out where the common ground lies is the difficult part. Hence the surprise and the negative response it evoked.

The Lega has been typified as a far-right party that advocates greater autonomy for the wealthy northern part of Italy and is keen on tax reduction and less central government interference. The Five Star Movement, however, campaigned on issues like universal basic income and increased government spending, policies closer to the hearts of voters in Italy’s less affluent south. Their anti-immigrant and anti-Brussels views are about all that unites them.

Ripples and waves

In stark contrast to the benign response to the initial election result, the reaction this time was off the scale. Yields on 2-year Italian government bonds rose over 180 basis points in one day, reaching a level of 2.8%, and the spread versus the German Bund widened to almost 300 basis points, while Italian stocks plummeted 12.5% from the levels seen in early May. So, has the ripple become a wave? That depends on how things develop from now on.

While it may be tempting to jump on the ‘Greece re-run’ bandwagon, there are a number of factors that debunk this notion. For one, the Italian economy is much larger: it comprises about 15% of recorded economic activity in the Eurozone, compared to just 1.6% for Greece and traditionally its economy and banking system are also much more integrated with the rest of the Eurozone. Italy is also the third largest debtor in the world (130% of GDP), after the US and Japan and, according to Deutsche Bank figures, only about 40% of this debt is domestically owned, with foreign investors (around 35%) and the Eurosystem (around 18%) owning the lion’s share of the rest.

Contrary to popular belief, Italian debt is not only held by Italians

Greek Tragedy 2.0?

Whereas Greece found itself backed into a corner and presented with an ultimatum – “comply or default” – as one of the EU’s founding members, Italy has far more leverage when it comes to negotiating with the other Eurozone members. Italy is simply too big to fail.

A second important difference is that where the Greek crisis was basically a product of unsustainable government policy, in Italy it is mainly a political matter. Despite its very high debt burden, Italy has managed to comply with the 3% deficit target since 2012 and has a pretty substantial current account surplus (2.5% as a percentage of GDP). And although it has been a structural laggard in the Eurozone, economic momentum has improved in recent years.

Coalition on collision course

So, will the sequence of events unfold into a full-blown crisis? From a more pessimistic perspective, joint control by the two populist parties now makes any progress on reforming the weak banking system or improving the economy improbable. And the new government may well start delivering on its election promises with budgetary plans that are likely to put it on a collision course with the European Union’s Stability Pact. Something which could cause a showdown later this year. It is difficult to predict whether the financial markets would simply sit back and watch in such a scenario.

On a more positive note, this fledging government may not last long enough to do any serious damage. Italy’s north-south divide is more of a chasm, so trying to put the two elements together in a single government is no mean feat – even under normal circumstances. But the fact that these parties also come from two different ends of the political spectrum makes the task at hand seem virtually impossible. The odds of these rivals falling out with each other increase with each day of collective government responsibility.

This last scenario seems to be the one most favored by the financial markets at present, with market tensions easing after the new government was installed. As the dust settles, we’ll just have to wait and see if Italy continues to make waves or whether it’s all just been a storm (ripple) in a tea cup.

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