How Italy could still knock the Eurozone off target
The old saying that “markets like to climb a wall of worry” is getting a good work-out this autumn. As if a rising oil price, a strong dollar, tighter monetary policy in the USA, emerging market debt crises and the Brexit negotiations were not enough for advisers and clients to ponder, they can now add Italy to the list.
After three months of haggling, March’s General Election eventually led to the formation of a coalition Government in Rome. The politically independent Giuseppe Conte is Prime Minister. But the real powerbrokers are his joint deputies, Matteo Salvini and Luigi di Maio, the leaders of the two largest parties in the Italian Parliament, the right-wing, regionalist Northern League and anti-establishment Five Star Movement, brainchild of the comedian (and still party President) Beppe Grillo.
Both parties had campaigned against austerity and the neoliberal centre represented by former PM Matteo Renzi. As such the Italian ballot followed the trend set by America and France, with outsiders from beyond the mainstream (and especially the centre ground) sweeping to victory in the manner of Presidents Trump and Macron. Brazil may be about to become the next nation to follow this path.
If this apparently global shift to the wider left or right of the political spectrum were not enough for advisers and clients to chew on, there are potentially more immediate economic and financial considerations at work in a purely European context.
Although it has seemingly scrapped its call for a withdrawal from the euro, the Five Star Movement remains fiercely Eurosceptic. And given their victory on an anti-austerity ticket, no-one should be surprised that the two leading Italian parties are now looking to push through a more expansive Budget, even if Brussels and the EU rule-makers are unhappy about it.
This immediately begs three questions:
- Why are markets as unhappy as the EU’s bean counters?
- How can advisers and clients tell?
- What are the potential implications for markets in Europe and possibly beyond?
The Italian Government has drawn up a Budget which has three key thrusts, all designed to boost growth and tackle unemployment, especially among the young:
- A universal basic income of €780 a month
- Tax cuts
- The abandonment of plans to raise the retirement age
As a result, Italy’s projected annual budget deficit for 2019 will be 2.4% of GDP, rather than the 0.8% agreed with the European Commission in 2017. Plans for a balanced budget by 2021 have also been scrapped.
Brussels seems unamused, arguing that the plans are not compatible with the prior agreement and wider European stability. Italy already has an aggregate debt-to-GDP figure of 130% and it is home to the world’s third-biggest Government bond market. It is too big to bail out.
The Italians may be entitled to feel miffed, given that France is forecasting an annual 2.8% deficit for 2019 and Spain 2.7% while in America the Trump tax cuts are being lauded as a key driver of growth even if they will take the annual budget overspend to 5% of GDP.
Watch the Target
Yet the markets seem as unimpressed as the EU authorities and this can be seen in two ways.
The first is a sell-off in Italian government bonds, or BTPs (Buoni del Tesoro Poliennali). The yield on the 10-year paper has rocketed to 3.58% as supply is about to increase just as the European Central Bank (ECB) prepares to stop its Quantitative Easing programme in December, knocking a potential buyer out of the equation.
Italian Government bond yields are rising again
Source: Thomson Reuters Datastream
The second is capital flight from Italy. This can be monitored via the Trans-European Automated Real-time Gross Settlement Express Transfer (or Target-2) mechanism. In essence the system is there to help balance trade flows but it also reflects capital flows – if a Spaniard parks cash with a German bank, the Spanish bank that lost those deposits now gets Emergency Liquidity Assistance (ELA), or funding from the ECB via an open credit line to make up for the loss of that cash. This is all well and good unless the recipients of that ELA funding default – as other EU members would share that pain.
Bulls (and for that matter Mario Draghi) argue that the Target-2’s smooth functioning shows that QE is working as it balances out the capital needs of the EU’s member nations.
Bears and sceptics of the single currency in particular assert that Target-2 flows merely highlight huge capital flight from the South. The good news is that eight Eurozone members are now in credit (up from five a year ago) – Germany, Luxembourg, the Netherlands, Finland, Ireland, Slovakia, Cyprus and Malta – and Greece’s deficit is still shrinking.
Imbalances are growing within the EU’s Target-2 system
Source: European Central Bank, € billions
The bad is that Germany’s positive balance is higher still and it still looks like money is leaking out of Spain and Italy. If this trend continues through 2019 – and the data is released with a two-to-three-month lag – it could in turn imply the Eurozone edifice is coming under increasing strain, with Germany and the select number of other creditors bankrolling the rest.
Banks back in the spotlight
Target-2 suggests Italy’s budget battle could have continent-wide implications, although any reversal of flows back south would be a positive sign.
More immediately, the concerns are strictly Italian. The rise in BTP yields increases the cost of funding for Italian banks and could restrict their ability to lend. Moreover, falling bond prices erode Italian banks’ capital, as they are huge owners of Italian Government debt.
According to analysis from the Bank of International Settlements, Italian Government debt represents nearly one-fifth of Italian banks’ total assets, more than 140% of the regulatory Tier 1 capital at leading lenders Unicredit, Intesa Sanpaolo and more than 200% of Monte dei Paschi di Siena’s Tier 1 reserves.
If bond prices keep falling, Italy’s banks will get weaker and if its banks and economy get weaker than its bonds could keep falling, in the very doom loop that the ECB launched QE to avoid. And if Italy’s banks wobble, the markets may start looking at who else is lending them money, if they are not already – the Stoxx Europe 600 banks index is already doing badly.
Italian and European bank stocks are performing poorly
Source: Thomson Reuters Datastream
None of these concerns have to be borne out. Italy’s Finance Minister, Giovanni Tria, is arguing that the annual deficit will start to shrink as economic growth accelerates (the same argument put forward by the Trump administration in the US).
But advisers and clients with exposure to Europe or the banking sector, via their chosen funds, may need to keep an eye on events in Rome over the coming weeks and months, just in case.