Escaping from the Italian Job

Last year, in spring, I was asked to speak at a conference in Italy on the shores of Lake Como: it was part of the global conference elite merry-go-round, hearing the same type of people saying similar things in different locations. Only this time, I heard things not usually heard. I was on a panel that included a former Italian PM (Enrico Letta, PM 2013-14) and the then Italian President of the European Parliament, Antonio Tajani, plus two others. I thought the British were euro sceptic until I ventured into what was a largely Italian focused debate. The great and good of Italian business – the ones unlikely to have voted for the just displaced Italian Government – made up the bulk of the audience.

In economic terms it was simple to diagnose the fundamental problem: a lack of demand and spending and hence weak growth in the Italian economy. In addition, the other key issue was the need for economic reform at home. Who to blame, then? The euro was the number one target, but no-one seemed to escape. What struck me then was how the split was regional: Bologna and north of there seemed to be in a very different space to the rest of the country. I did leave wondering that if this was what the business community was thinking then what was the rest of the country like? Now we can see.

What has happened?

In this March’s Italian elections there was no clear winner. There was nothing new about that. Also, it took ages for a Government to be formed; again, nothing new. This is common in Italy and Europe. Even Chancellor Merkel took five months to form her current Government in Germany.

The markets were worried about the likely policies of the new coalition Government, made up of two extremist and euro sceptic parties – the left leaning Five Star Movement and the right wing Northern League. But worries were contained as the parties had to compromise on their united policy and some ideas – like a debt write-off – were effectively discarded.

However, over the last week, their proposed choice of a Eurosceptic Finance Minister Paolo Savona was overruled by the President, Sergio Mattarella. While the President was acting within his rights, his handling of the situation did not go down well. In response Giuseppe Conte, who was to have been the PM of the Five Star-League Government, said he would not offer a replacement and consequently form no government. Apparently, the root of Mattarella’s decision was that in Savona’s recent book, the 81-year-old academic had written, “We need a plan B to get out of the euro if necessary ... the other alternative is to end up like Greece”. This hardly sounds radical. If anything, it sounds sensible.

Italy is divided politically and now, because of what appears to have been a mishandled political situation in recent weeks, financial markets are worried – and earlier this week they panicked, with Italian bonds and the euro selling off.

What next?

The President thus asked an austerity minded former IMF technocratic economist Carlo Cottarelli to run an interim Government. Even though this is not the first technocratic, Brussels-supported Government – there was one only a few years ago under Mario Monti, PM 2011-13 – this time the markets fear the consequences. The euro is a fundamentally flawed concept that exerts a deflationary mentality into policy making. The reason it has survived is because of politics not economics – even Greece did not want to leave the euro lest they had to exit the EU. Indeed, the idea of a Plan B would seem to fit with President Macron’s suggestion over the last year of either the EU moving quicker to closer political union or to a two-tier approach with a core and periphery.

All of this suggests the markets are premature in assuming events in Italy will lead to their exit from the euro or EU anytime soon.

But the feeling is that anything is possible. Whatever temporary measures are put in place, new elections are widely expected to be held, either soon or next year, and in current circumstances the parties just discarded from Government (Five Star and the League) may do far better. It remains to be seen whether either party will run their campaign with a commitment to leave the single currency, but putting that decision in the power of the people would be a huge risk.

Italy leaving the euro may make long-term economic sense. But it did, too, for Greece and they baulked at the prospect. More likely Italy will remain. Staying in the euro forces Italy to remain competitive by keeping domestic costs down and reforming. The northern part of its economy, helped by a different economic structure to the rest, appears able to cope. Other parts of the country do not. This has led to high unemployment – and on top of this has been the migration crisis.

Deep-rooted problems

According to surveys of public opinion (such as a recent one by YouGov) the two big economic issues in Italy are unemployment and immigration. At the time of the global financial crisis the Economist famously highlighted that the three weakest economies of the previous decade were Zimbabwe, Haiti and Italy. Italy had barely registered annual growth of one per cent and that was at a time when the world was booming. In the decade since it has shared the same problems of other Southern European economies, with weak growth triggering high unemployment, especially among the young. Some blame the euro, others the lack of reform in the Italian economy. It is likely a combination of both.

What is remarkable perhaps about the current crisis is why now? Growth is now recovering, helped by the cheap money policies of the European Central Bank (ECB). Of course, growth really needs to be far stronger to make inroads into existing problems. Its debt to GDP is 130%. Thus, if the rate of interest Italy pays on its debt exceeds its rate of economic growth then it falls into a debt trap where rising interest payments become harder to meet and the debt level rises. That would be the fear because of latest developments.

Admittedly much of the debt is domestically owned, which is better than if it was held overseas, as there is less likely to be aggressive selling. Nonetheless rising yields have also thrown attention onto the fragile position of Italy’s banking sector.

The Netwealth portfolio impact

Across GBP and USD denominated portfolios, we are not exposed to Italian bonds and within the EUR range our exposure is limited. There is, though, exposure to Italian equities in several of the portfolios through our allocation to European equities, however, the country weight of Italy within European indices is less than 7%. Despite the near-term turbulence, the current fundamentals of the European recovery remain solid but will be sensitive to monetary tightening. We do not expect Italian domestic issues to have a wider negative economic growth impact, especially if the ECB keeps policy loose and the recovery in the global economy continues. Additionally, we have no direct exposure to the euro in GBP denominated portfolios, as we chose to fully hedge the currency component of the equity position, precisely to protect against situations such as these.

So far, the contagion to other European markets has been limited – in part that is because the transmission is via politics and other countries are committed to the euro project, although certain sectors, banks especially, have suffered more than others, given their high exposure to sovereign debt.

The cyclical recovery in Italy and elsewhere in the euro area should alleviate some of the market’s worst fears and limit worries about contagion, but the deeper message is clear: that economic reform and further change is needed in the euro area. It probably means a political risk premium will be reflected into Italian assets until this latest crisis resolves itself.

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