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Economic Insights

Tensions have raised concerns about the future of the country’s membership in the European Union—and the euro.

 

In Brief

  • Global asset markets were slammed by news that Italy’s president blocked the formation of a government by two parties that have made demands that are inconsistent with the terms that Italy agreed to in order to adopt the euro as its currency.
  • Growing “euroskepticism” fuels worries about the continued cohesion of the European Union and the euro.
  • The stakes are higher than during previous European political/fiscal crises, given the size of Italy’s debt.
  • Daunting fiscal and political challenges may affect Italy’s ability to service its sovereign debt, which recently totaled 131.8% of its gross domestic product.    
  • The key takeaway: Any improvement in the political situation could relieve the pressure on Italian bonds and stocks, but the political and fiscal drama will take some time to play out.

 

In an earlier commentary on lordabbett.com, we discussed the possibility of “Exitaly”—the departure of Italy from the European Union and the common currency, the euro—in light of the election on March 4, 2018, which was dominated by two euroskeptic parties, Five Star and the Northern League. Fast forward to late May, and the issue has become far more urgent. On May 27, Italian president Sergio Mattarella blocked the formation of a coalition government assembled by Five Star and the League, raising the prospect of new elections. As a Wall Street Journal report noted, investors worry a new vote could strengthen the hand of anti-eurozone forces.

The news jolted asset markets worldwide in the subsequent days, pummeling prices of Italy’s stocks and sovereign debt, with equities elsewhere in Europe and the United States also coming under pressure. The renewed concerns about the status of the eurozone sent the euro sharply lower versus other major currencies, while the U.S. dollar strengthened.

Despite the jarring price movements in recent days, things could become much worse before sufficient pressure develops to force changes that would compel the government to live up to prior commitments. Remember that Italy is much bigger than two other notoriously distressed economies in the region, Greece and Cyprus; therefore, if the situation escalates, the threat to eurozone economies, and particularly their markets, will be much more substantial than it was during the crisis years of 2010–12.  The price of credit default swaps on Italian sovereign debt—which had remained fairly stable, since 2012, following the statement by former European Central Bank president Mario Draghi to do “whatever it takes” to defend the euro—has responded in kind (see chart below).

 

Political Uncertainty Boosts Prices of Italian Sovereign Credit Default Swaps
Cost of credit default swaps on five-year Italian sovereign bonds, May 30, 2011–May 28, 2018

Source: Bloomberg. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  

 

Italy’s fiscal challenges are formidable. With low nominal gross domestic product (GDP) growth—which has averaged only 0.6% over the last 10 years and 1.3% over the past five—the nation’s ability to service payments on principal and interest of its sovereign debt requires average financing rates no higher than 3.5–4.0% and a primary budget surplus of around 4% of GDP. While average financing rates adjust slowly, a rapid rise in bond yields, to a range of 3.5–4.0%, could spook markets into questioning debt sustainability in the long term. Meanwhile, the Organisation for Economic Co-operation and Development estimates that the primary surplus will average just 1.7% in 2017–18.

The major credit rating agencies currently rate Italian government debt above junk status by either two notches (by Fitch, Moody’s, and Standard & Poor’s) or three (by DBRS, the largest ratings agency in Canada). All four agencies will update their ratings between July 13 and October 26, 2018. If Italy’s debt is downgraded to one notch above junk, it could cause bondholders with investment-grade restrictions to start exiting Italian debt more than they already have. To qualify for purchase or reinvestment by the European Central Bank (ECB), Italy must retain at least one investment-grade rating. To qualify for emergency funding by the European Stability Mechanism (ESM), Italy would have to agree to an International Monetary Fund-style fiscal reform package (such as spending cuts and tax rebalancing).  

Regardless of what shape a future government assumes, the chances of Italy reaching the point of “Exitaly” are still small, given polls which reveal that most Italians want to continue the nation’s participation in the euro—though we think a worsening political environment may erode that support in coming months. However, if uncertainty continues to increase, adverse financial flows could cause a vicious cycle to begin, in which the euro “leaves” Italy, even if Italy does not leave the euro.

Thus, the risks remain significant. With the yield on the generic 10-year Italian government bond shooting up to 3.15% on May 29 (it had been at 1.71% as recently as April 18, 2018; see chart below), the chances for a vicious spiral amid yields, ratings, and sustainability to develop are becoming quite real.

 

Italian Yields Shoot Higher Amid Political Uncertainty
Yield (%) on generic 10-year Italian government bond, January 26, 2018–May 29, 2018

Source: Bloomberg. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Past performance is not a reliable indicator or a guarantee of future results.

 

Investment Implications
The current situation, clearly, is in its early stages—and conditions could change rapidly. Italian bonds could rally, for example, if the political scene shifts toward a centrist coalition made up of Italy’s Democratic Party and Five Star. Or the bonds could sell off sharply if Five Star and the Northern League reaffirm their intent to pursue a coalition after the next election that will implement the same fiscal program they already have proposed.

Meanwhile, what concerns should we think about regarding the stocks in the Italian and European markets? Back during the 2010–12 period, for example, the MSCI Euro Index dropped 37.5% from peak to trough (in U.S. dollar terms) amid the Greek sovereign crisis and the consequent double-dip recession. By historical comparison, European equities (eurozone and non-eurozone) are not particularly cheap on forward earnings estimates compared with those in the United States, with the relative forward earnings multiple of European stocks within 1% of its 25-year average versus U.S. stocks. With risks of a systemic macro shock rising, it could be argued—at least by us—that Europe currently is not an attractive place to take equity risk and that a portfolio underweight in eurozone equities is justified.

A Final Word
While Exitaly is a portmanteau cousin of the United Kingdom’s breakaway brand name, Brexit, the similarities end there: while the United Kingdom was a member of the European Union, it was not part of the euro.  Further, Italian government bonds are widely held by banks in the eurozone, at zero risk weights—that is, classified as risk-free for investment purposes and, therefore, requiring no reserve cushion on banks’ balance sheets—posing a threat to the eurozone banking system that U.K. debt never did. (By way of comparison, the U.K. debt-to-GDP ratio was 83.5% in 2017, while Italy’s now is 131.8%.)

As we pointed out this year in March, the Brexit example shows that elegant and rational solutions to difficult problems sometimes prove elusive, even for countries that have been under less stress than Italy has been in recent years. Thus, developments in Italy must be monitored very closely—and we will comment on the situation as events unfold.

 

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