The word ‘crisis’ is defined in the Oxford English Dictionary as “a time of intense difficulty or danger”.
This implies that it is extreme circumstances that usually cause a crisis. So how do the recent Italian political worries stack up on this definition? On the surface, there isn’t much to worry about. There’s nothing extreme about a political stalemate in a country which has had nearly 70 different governments since the war. There’s also nothing extreme about voting into government a political party set up by a comedian in a country that gave Silvio Berlusconi four shots at running the government. However, when politics, extreme or not, could impact the economic situation, investors tend to take note.
The economic situation in Italy is unique. Most countries experienced huge change following the Financial Crisis – changes that attempted to avoid the same problems again. Italy though, has always felt like the scratch that was not quite itched. The US implemented (heavy-handed) bank reforms; Spain saw a huge rise in unemployment; and Greece basically went through a depression. Italy just kept its head down: it shrunk a little; it grew a little. Some people got fired, some people got rehired. Some reforms were passed, some reforms were rowed back on. Bond yields went up, bond yields went down. The market’s worst kept secret is that while everyone scrambled to find ways to avoid another crisis, Italy never bothered.
The country’s economic problem is longstanding – the economy is suffering from chronic stagnation. Since the formation of the Eurozone, it is the worst performing economy in the monetary union, even worse than Greece. Italian banks are still sitting on a large pile of unresolved bad loans, and Italy’s best and brightest continue to head to stronger parts of the European Union (which as we mentioned above, is everywhere else). The Italian economy is just over half the size of the German economy, but has a debt load of a similar level. The cost of servicing this debt acts as a drag on the economy, while the slow economy does nothing to bring the debt burden down. This vicious cycle is slow moving and relies on a combination of government frugality and nothing going wrong in the global economy to keep a lid on it.
“The market’s worst kept secret is that while everyone scrambled to find ways to avoid another crisis, Italy never bothered.”
This is where the politics comes in. While the headline writers have continued their habit of blending words, “Quitaly” remains unlikely, as the populist parties are not running on a platform to leave the Eurozone. What the populist parties are promising, is to reject European fiscal compacts and to increase domestic spending – this is why people vote for populist parties. If this increase in spending doesn’t threaten the country’s debt burden, the bond markets voting with their feet might. Last Tuesday saw the biggest one day change in Italian bond yields since 2011, putting the country’s debt on a precarious path if nothing is done. The thinking goes that once this happens, Italy has no choice but to leave the Eurozone, as it simply will not be able to pay the high rates of interest demanded by the market – at least not in Euros.
We believe that extrapolating the events of last week and forecasting a disaster is not sensible:
- First, it’s too early to tell if the coalition (the operative word is coalition) among the populist parties will actually be able to agree on and push through ruinous spending policies.
- Second, the recent past has taught us not to underestimate wider European pragmatism in these situations – Brussels is well versed in giving just enough in times of crisis to kick the can down the road.
- Third, the recent past has also taught us to ignore the bluster of populist parties – they often receive a reality check once in office, and bond markets can be very persuasive.
- There are also some other things being ignored: the electorate remains pro-European; the country has been sleepwalking towards competitiveness by standing still while wages in Germany have boomed; once interest costs are accounted for, the government spends less than it receives in taxes; and according to most projections, Italy’s debt level is actually expected to shrink this year, even with this little wobble.
We expect the situation to be resolved as it remains in the interest of all parties to do so. Because of this we maintain a neutral position on equities and an overweight to Europe – valuations still look attractive versus the US, even when accounting for the higher profitability of American companies. Once this situation is resolved, we expect investors to refocus on what’s important – European growth, earnings momentum and ECB policy. However, we do not discount that it may take an extreme market reaction to get the right people around the table. As such, we hold equity put options and US Treasuries to help mitigate the risk of a market sell-off. We continue to monitor the situation and are ready to act where necessary. We could be in for a volatile summer – but we also had a volatile spring, and the world didn’t fall apart!
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