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Italy’s Political Impasse Rattles Global Investors as Europe’s Existential Threat Resurfaces

Published May 30, 2018

The risk of a Eurozone implosion returned to haunt investors this week, as Italy’s failure to form a government led to risk-off moves around the globe. On Tuesday, Italian bonds plunged, US Treasuries rallied, while both the euro and oil fell. Major stock indexes also fell, with bank stocks especially hard hit. The gap between 10-year German and Italian bond yields has now risen above 2.5 percentage points, the widest spread since 2013. European banks, in particular, took a beating. Pan European STOXX ® 600 closed 1.37 percent lower on Tuesday, while European banks experienced their worst losses since August 2, 2016. Together with greater political uncertainty in other parts of the European Union (EU) such as Spain and the UK, fears of a disorderly end to the European project have risen to the surface again.

The failure to form a government has led to a call for new Italian elections. EU supporters fear that anti-EU populists in Italy might build upon their gains in the March elections and force a referendum on EU membership.  A vote by Europe’s third-largest economy to leave the EU would represent an existential threat to the entire European project.

Debt Remains Biggest Burden

Italy’s government remains the fourth largest borrower worldwide, raising approximately EUR 240 billion in 2018 alone. The Italian debt management office has skillfully taken advantage of the low yield environment to extend the average maturity of government debt to nearly seven years. This has reduced the pressure of managing the country’s EUR 2 trillion of debt stock, yet Italy still needs to roll over sovereign debt worth about 16% of gross domestic product (GDP) every year – the highest rate in the Eurozone.

Such debt servicing capacity requires a prudent policy framework. Fortunately, Italy has been fiscally very responsible in recent years. The debt overhang is a legacy issue from the 20th century, as Italy has been running the largest primary surplus (net budget surplus before interest payments) in the Eurozone post 2008 at an annual average just below 1.5% of GDP and recently close to German levels.

Italian domestic banks are in the front line, though there are also concerns that Italy has a disproportionately large share of “zombie” companies that will be unable to cover their interest payments if Italy lapses back into recession. Notably, banks outside Italy with significant exposure to Italian debt, such as BNP, have also seen their shares suffer.

The sell-off in Italian government bonds has been very sharp, with the bearish flattening of the yield curve particularly notable. In effect, this indicates the market is pricing in an increased chance of a re-denomination or default on Italian debt. It should be noted that the implied probability of this is still low, and it is not our base case at the moment. An important question is at what stage the European Central Bank (ECB) might step in to provide support. We believe the ECB is unlikely to intervene unless market contagion becomes too large to ignore. Italy is too large for the current backstops to deal with, so the ECB would need to create a different support mechanism.

While spreads on non-core European markets such as Spain and Portugal have widened, the sell-off there has been much more subdued than in Italy.  The danger is that a further move wider in Italian yields could be seen as more systemic and might feed into a more aggressive widening of spreads in these and other lower-rated markets.  We have not seen domestic Italian investors coming back to the market to buy Italian bonds following the recent widening.  Reassurances of staying within the EU and reversing commitments to significant fiscal spending would need to occur to entice domestic investors back. Given the recent volatility and reduced liquidity in markets, we remain neutral on Italy in our portfolios.  We are not reducing exposure to Italy or other spread sectors at this time and are looking for signs of stability to selectively add risk in sectors of the market that have been impacted by spread widening.  Given the uncertain political backdrop, however, it may take some time for this stability to emerge.

Where Do We Go From Here?

The new elections will be an important barometer of Italy’s next moves, as Italian populists appear to be clinging to extreme views. A strengthened populist government would lead to a direct showdown with bond markets and Brussels institutions.  As we noted on the morning following Italy’s first round of elections in March, without fundamental EU reforms, an increasingly anti-EU Italy could eventually become too great a problem for the Eurozone to manage. While there is still room for EU reform to offer a solution, it is increasingly looking like a more binary outcome of Italexit or a populist surrender to the realities of Italy’s bondholders and European regulators (as we saw happen in Greece). Neither is very appealing for investors holding Italian assets, as performance will deteriorate in either case.

Today’s market volatility once again demonstrates the importance of haven assets like US Treasuries and gold as portfolio buffers against inevitable market turbulence.

Definitions

Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period.

STOXX Europe 600 Index: An index designed to track 90% of the free-float market capitalization of the European stock market.

Yield Curve: A graph that compares interest rates of bonds with equal credit quality but different maturities.

Disclosures

The views expressed in this material are the views of Esther Baroudy, Elliot Hentov and Brendan Lardner through the period ended May 29, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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