The following report was originally written and published by Michael Stritch, CFA, Chief Investment Officer and National Head of Investments, BMO Wealth Management – U.S. For more information on BMO Wealth Management, click here.
After a few months of relative calm, the past few days have provided an ample reminder of the fragile political reality in Italy. The fourth1 largest member of the European Union (E.U.) has reasserted itself as one of the preeminent long-term risks to the broader European economy and markets.
Ten years after the financial crisis, and six years since the European sovereign debt crisis, Italy remains (on a relative basis) stuck in the economic mud. Real GDP is well below the pre-crisis peak, and unemployment still hovers near 11%. It is against this backdrop that Italian politicians and citizens alike have begun to direct more blame towards the fixed currency requirements, strict fiscal controls, and immigration policy of the E.U.
As stated previously, this populist trend was confirmed in the recent general elections. While no group won an outright majority, the anti-establishment Five Star Movement (M5) and Eurosceptic league parties emerged as two new political forces. We speculated this outcome would eventually lead to market volatility, and that reality was achieved last week when the incoming government finally put forth formal recommendations for key leadership positions. The economic ministry pick was especially controversial given the choice, economist Paolo Savona, has previously been a vocal critic of the single European currency. As a result, President Mattarella vetoed the selection by maintaining the candidate’s anti-E.U. views did not align with the more moderate campaign pledges made by both the League and M5 this winter. President Mattarella instead appointed former IMF official, Carlo Cottarelli as interim prime minister and he intends to present a “neutral” cabinet. The next step is a confidence vote in parliament and if, as expected, the majority votes no confidence then Cottarelli has promised to hold new elections in the fall. Should that happen, it is likely that Italy’s E.U. membership terms will be a focal point of the vote. News of these events sent a tremor through Italian political circles, and unnerved the broader global markets as well.
While more uncertainty lies ahead over the next few months, we think an “Italexit” seems unlikely and the new government will ultimately back down from many of its more populist proposals. Polls show a majority of Italians still favor E.U. membership though, candidly, at a lower percentage than other European nations. In addition, we expect European economic activity to recover after a Q1 slump worsened by poor weather, holiday timing and a bad flu season. This should provide a marginally improving backdrop for Italian businesses and workers. Ultimately, however, it will be the bond market that may force the M5 / League coalition to take a more somber tone. In the past few days alone, Italian bond yields relative to German debt (a key risk proxy) have soared to levels not seen since 2014. While not to the heights of the European debt crisis, this sharp spike reminds us that the market moves much more quickly than political agendas. Not only will rising rates hurt the Italian economy, but Italian treasury bonds make up a significant portion of the capital supporting the country’s financial institutions. A dramatic bond selloff, therefore, could drive Italian banks towards insolvency. This would, of course, severely undermine any attempts by the new government to improve financial conditions.
At this point, we are not altering our non-U.S. equity positions, but will be monitoring the situation closely. Expectations for a growth rebound, relatively attractive valuations, and the prospect that the European Central Bank could take a more dovish turn in support of any further contagion all suggest investors stay the course. We acknowledge, however, that risks have risen and if the Italian political landscape looks poised to weigh down economic prospects in the region, we would consider an adjustment in our stance.
1The U.K. is slated to leave the EU formally in 2019.
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