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Italian Contagion: So Far, It’s More About Fear Than Fundamentals

What’s Going On?

Almost three months after an inconclusive election left Italy without a government, the country may be heading for yet another election; one that could be critical for Italy’s membership in the Eurozone.

Two anti-establishment parties came out as the biggest winners of the last election: The leftist 5 Star party (“M5S”) favored in the impoverished Southern parts of Italy, and the Northern League party (“the League”) favored in the wealthier, industrialized North. But neither had enough votes to form a government alone, so their only option was to ally to form a coalition government.

As we noted in our March 7 DIBs report, Italy Breaks with 70 Years of Pro-European Hegemony, the M5S and the League share common ground in several important areas: Their anti-austerity stance means they both want to roll back pension and labor market reforms, they are okay with increasing Italy’s budget deficit to fund fiscal expansion, they distrust free trade, and they are both Eurosceptic, believing Italy would fare better outside the single currency bloc. We also noted that despite their shared views, forming a coalition government would be a challenge, as they are different political creatures with bases that are not economically or philosophically compatible.

Nevertheless, M5S and the League painstakingly managed to put together a program of government that would include university professor Guiseppe Conte as prime minister, and economist Paolo Savona as finance minister with responsibility for Italy’s economic and fiscal policies.

This weekend, however, Italian president Sergio Mattarella vetoed Savona’s candidacy as finance minister on the basis that the choice would destabilize the markets and risk a euro exit. Mr. Savona has been a persistent critic of the euro and allegedly even authored a plan for extracting Italy from the single currency union.

Under Italian law, the president has the constitutional right to block the appointment of a major official. President Mattarella’s rejection of Savona not only derailed the populists’ efforts to form their government, it also prompted calls for another election to be held in a few months.

Why Does This Matter?

The decision to hold new elections has rattled global financial markets because it could threaten the long-term viability of the European Union, which is facing several political fires right now. With Italy’s pro-EU and anti-EU factions at loggerheads, many fear the coming election may become a de facto referendum on Italy’s membership in the union. As the EU’s third largest economy, the outcome could be disastrous from the market’s perspective.

Fears of a potential “Italexit” or “Quitaly” have triggered an aggressive selloff of major European assets, bringing back memories of 2011/2012 when one country’s crisis had the contagious effect of spilling over into other European economies.

STOCKS: All the major Western European benchmarks, except for France, have seen their 2018 gains wiped out. Just over the past month, the iShares MSCI Eurozone ETF (EZU) has fallen more than 5%, while the iShares MSCI Italy ETF (EWI) has plunged 14% during the same period.

BONDS: Yields have surged on Italian bonds and those of periphery EU nations such as Spain, Portugal and Greece. Italy’s benchmark 10-year yield rose nearly 50 basis points (bps) to 3.16%. At some point, the yield on Italian two-year government debt rose an astounding 49 bps, nearly hitting 1%. Greece’s 10-year yield climbed 47 bps to 4.81%. For Spain and Portugal, their 10-year yields rose 7 and 12 bps, respectively. Meanwhile, the cost of insuring exposure to these debts also soared on Tuesday, with Italian 5-year credit default swaps (CDS) leaping to 227 (bps), up 51 bps from Monday’s close. Just two weeks ago, the CDS had traded at 96 bps.

FX: The euro too has dropped to $1.1541, the lowest level of the year. Some analysts believe there is a greater likelihood that it will tumble further to 1.10 by the end of summer rather than recovering to 1.20 over the same period. Ultimately though, the directionality of the Euro will be determined by the ECB’s monetary policy and bond-buying program.

This feels a bit like déjà vu. Any trouble in the eurozone unfailingly triggers talk that the euro project is doomed to fail, and panic ensues in the markets. The severity of the recent downdrafts and the spillover beyond Italy seem to be driven by fear rather than fundamentals. Last year, the eurozone’s economy expanded at its fastest pace in a decade, and unemployment dropped to the lowest since the global financial crisis. Economic conditions in 2018 are vastly improved from 2012, especially for Spain, Portugal and Greece which now have lower budget deficits, and whose debt-to-GDP ratios have stabilized. Greece even looks set to exit its bailout program this fall.

So, while it is true that Italy remains one of the most indebted countries in the world, after Japan and Greece, panic about Italy leaving the euro or pursuing policies that could lead to a default of its sovereign debt are premature at this point. ECB chief Mario Draghi helped end the 2012 crisis by promising to do “whatever it takes” to stabilize markets. Back then, Greece was the problem; today it’s Italy, one of the three most crucial members of the EU, along with Germany and France. It would be surprising if the “whatever it takes” did not apply here.

Furthermore, it’s not clear yet what platform the populists will run on in the new elections. Italians, for the most part, like being part of the EU, and may not be comfortable voting for campaigns that outright advocate pulling out. Indeed, analysts say it is unlikely that Italy would stop using the euro soon.

For now, political uncertainty around Italy will drag on for the 2-4 months until the next election, and possibly beyond that as the country attempts again to form a government. Investors are therefore advised to approach Italian assets with caution, until greater clarity emerges.

Investors seeking exposure to EU or Italian equities can accomplish this via the iShares MSCI Eurozone ETF (EZU) and the iShares MSCI Italy ETF (EWI).


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