PMC Weekly Review - June 08, 2018

A Macro View: Italy’s Political Strife: No longer a Dolce Vita

We could be forgiven for thinking Europe was a trouble-free haven of stability. After all, investors have flooded into its capital markets, chasing a glut of
super stimulus from the European Central Bank (ECB), economic recovery has flourished, and political problems appear to be a thing of the past. Even
Greece has been welcomed back into the global lending club. European unity has never seemed stronger.

It’s time to take off the rose-tinted glasses!

Last week, Italy’s political turmoil roiled global financial markets and raised questions about the country’s future as a member of Europe’s shared
currency, the euro. Prime Minister Giuseppe Conte, a law professor, was given a mandate to form a government. Conte’s appointment could herald an
end to more than two months of political uncertainty in the eurozone’s third-largest economy. But the anti-immigrant stance of the Five Star Movement
and the right-wing League (Italy’s two leading parties), has alarmed senior European officials. The joint government program unveiled by the parties
pledges significant antiausterity measures, such as drastic tax cuts, a monthly basic income, and pension reform rollbacks to boost Italy’s growth.
European Union (EU) officials have voiced concern that Italy could trigger a new eurozone crisis by refusing to stick to public spending and debt targets
set by Brussels.

This has sparked memories of the Greek crisis that engulfed the eurozone in 2014. Investors raised concerns that political leaders might push for Italy to
leave the euro, sending markets and bond prices tumbling. More importantly, an Italian debt default would amount to a nuclear disaster for world
financial markets. Not only would it be game over for the euro, but it could drag investors into another downward spiral. Considering Italy’s current
political malaise, the possibility of global contagion is not that far-fetched. Meanwhile, Moody’s said that Italy’s credit rating could be downgraded if the
next government does not come to grips with its huge debt pile. It’s no surprise that Italian consumer confidence was weaker than expected in May.

The best gauge of risk in any European bond market is a comparison with Germany’s yields, as it is considered the continent’s safest country to lend
money to. Before the recent political flare-up, Italy was paying a one-percentage-point euro premium over Germany’s borrowing rate for a 10-year loan.
That gap—which nearly tripled last week (3.07%)—has dropped back to around 2.7%. Stock markets were also under pressure, although they have since
recovered from last week’s worst levels, with Italy’s FTSE MIB down 2.3%. Elsewhere, Germany’s Dax is down 1%, Spain’s Ibex lost 2.3%, the FTSE 100 fell
1.25%, and in the US, the S&P 500 declined 1.16%. The euro dropped to an equivalent of $1.1510, a new six-and-a-half-month low against the dollar,
before regaining some ground to $1.1580. Investors retreated from equities, their appetite for risk sapped by Italy’s crisis and a consequent rally in safehaven
assets, including U.S. Treasury bonds, gold, and the Japanese yen.

Italy’s new coalition takes over, with Italian yields far lower than at their peak, but the market’s loss of faith remains the greatest threat to its ability to
implement its unorthodox policies. Everyone recognizes that Italy has a debt problem. Its €2.26 trillion ($2.6 trillion) debt pile is the largest it has ever
been, and at 131% of gross domestic product, the third-largest in the world, behind only Japan and Greece. Yet, last year Italy paid the least interest on
that debt—€65.6 billion—than at any time since 1995, the beginning of the ECB’s data. According to the Organization for Economic Cooperation and
Development (OECD), Italy’s interest cost this year is expected to be the lowest in 40 years, relative to the size of its economy, although its 3.5% rate is
still the highest of any other member of the club of industrialized countries. Even so, ultra-low interest rates make a debt mountain manageable.

So far, the bond selloff is too small to upset this relatively amicable situation. But over the next two years, Italy must refinance €509 billion ($600 billion)
of maturing bonds, amounting to 30% of GDP, according to the ECB. The market’s trepidation of the coalition (or lack thereof) means Italy already will
pay significantly more, with yields on bonds ranging from 2 to 30 years rising half a percentage point or more in the past month. The relatively small
increase will add billions of euros to the cost of the new debt.

Fortunately for the coalition, bond yields are still lower than on the debt that is maturing. In fact, much lower: The average fixed-term bond (ranging
between seven and eight years) costs the government 3.2%. Refinancing everything should still shave a couple of billion euros from the annual interest
bill, albeit less than before the selloff.

If the markets lose faith in to the new coalition government, this could quickly have dire financial consequences with Italy suddenly struggling to
refinance its debt. Then, the European Financial Stability Facility (EFSF) would have to kick in. And the European Central Bank may decide to raise its
interest rate, reduce its bond buying, which would automatically make Italian government bonds more expensive. This could have fatal consequences
for an economically weak and politically unstable Italy. The European Union would have to loan Italy hundreds of billions of euros; bailing out Greece
would almost pale in comparison.

Nonetheless, hostilities with the EU appear to be inevitable, with the survival of the government far from certain. Whichever direction the new Italian
government takes, it is evident that this new alliance will be another burden for the EU.

Ed Zablan
Senior Investment Analyst

Reuters, Financial Times, OECD

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