Will the turmoil in Italy, the euro area’s third-largest economy, fracture the eurozone and ultimately spell the end of the single currency?
At this stage, almost anything seems possible. Yet while the longer-term results – and the implications for the investment management community –
remain to be seen, for me, two immediate lessons stand out:
Italy’s political brinksmanship as the anti-establishment Five Star Movement and far-right League struggled to form a coalition government has certainly produced a bumpy market ride for
Proposing the eurosceptic Paolo Savona as finance minister, and putting forward an economic program based on tax cuts and significant spending increases, was always going to ruffle feathers.
President Sergio Mattarella may then have been within his remit in vetoing the choice of Savona. But pitting the presidency against the democratically-elected parties added to a sense of constitutional crisis, and may well have strengthened the populists’ cause.
It also sparked a global sell-off and renewed fears of eurozone contagion.
The reason: with the interim technocratic government that was being assembled likely to lose a parliamentary vote of confidence, fresh elections loomed, potentially as early as July – elections that would have been seen as a de facto referendum on Italy’s membership in the euro.
Not surprisingly, investors got spooked. Global stock markets plummeted. The euro tumbled to a 10-month low. Italian government bond yields spiked, while safe-haven US Treasury bonds and German bunds rallied.
Concerns of impending doom have now eased. The choice of an alternative finance minister in place of Savona paved the way for the creation of the new Five Star Movement/League government. Global stock markets bounced back. Italian sovereign yields have fallen (although they remain elevated).
But the recent events in Italy have highlighted some serious underlying frailties in both the eurozone and wider European Union.
The eurozone crisis of 2011 and 2012 may have been triggered by Greece, but the real fears centered on Italy – with its massive debts – and the links to Europe’s fragile and heavily-exposed banks.
Italy’s banks have diversified their portfolios. Yet Italian sovereign bonds still make up almost 10% of their assets, maintaining a “doom loop” between the country and its banking system. Having failed so far to properly clean up their balance sheets following the financial crisis, the banks are also still burdened by a mass of non-performing loans.
Eurozone reform is much-needed, but highly contentious.
Some countries argue more risk-sharing, with greater funds made available to help under-pressure nations, would guard against future turbulence. Others, led by Germany, are wary of risk-sharing unless there are guarantees that countries maintain greater fiscal discipline (which Italy’s new government seems to be opposing).
The ultimate solution to the eurozone’s inherent problems would be a fiscal union. But that would also require political and banking union – a proposition unlikely to gain favor anytime soon.
The European Union also faces threats. The EU Single Market is built on four freedoms: the free movement of goods, services, capital and people. However, anti-immigrant sentiment was a feature of the Italian election campaign – not to mention the Brexit referendum and a number of recent elections elsewhere in Europe.
Italy’s new prime minister, Giuseppe Conte, used his first policy address to denounce Europe’s “failed” immigration policy. With a populist “Italians first” approach gaining support, Italy’s stance towards free movement is under scrutiny, putting pressure on the very foundations of the Single Market (as German chancellor Angela Merkel has acknowledged).
In short, the political and economic strains that have flared since the Italian election suggest it is only a matter of time before the next eurozone/EU crisis erupts. But when, and how, is anyone’s guess.
With hedge fund, wealth and asset manager margins and profits already under pressure, it is doubly important for funds to get a tight grip on their costs. With your own house on stronger ground, you’ll then be better placed to withstand the next storm whenever it hits.