by Joseph V. Amato, President and CIO, Equities, Neuberger Berman
On Tuesday, the political developments in Italy looked set to trigger the latest big correction in markets. By Wednesday morning investors had moved on, convinced there was nothing more to see. Italian politicians’ fractious attempts to form a government caused some remarkable market moves—the country’s two-year bond yield leapt by more than 180 basis points, a genuine “tail event”—and yet the systemic spillover was modest.
Nonetheless, the episode was a reminder that the euro zone still faces structural impediments that could present systemic risks. Politicians and investors have been trying to ignore these risks since Mario Draghi made his “whatever it takes” pledge six years ago.
Italy Is a Microcosm
It is worth noting, as my colleague Ugo Lancioni did last week, that Italy’s two-year yield was negative just a few weeks ago. Last Tuesday, German Bunds caught a modest safe-haven bid and the 10-year U.S. Treasury yield fell by 15 basis points. Yields in Spain (suffering its own political turmoil) and Portugal spiked. Credit spreads widened somewhat and global banking stocks were down. Overall, however, the contagion was negligible given the unprecedented sell-off in Italian two-year bonds.
Remarkably, when the Lega-Five Star Movement coalition builders appeared willing to propose a less euroskeptic finance minister rather than force a new election, it was enough to spark a relief rally for risk assets. Perhaps that rally was justified given that Italy did finally have a government in place by Thursday night—albeit with the same euroskeptic installed as minister for EU affairs.
In reality, the market response ignores Italy’s difficulties, which are a microcosm of the difficulties of the euro zone as a whole. It is a wealthy country with a booming export sector. But its wealth, and wealth creation, is concentrated in a northern region with little sense of solidarity with the south. Here, a poor, underemployed, aging population has had to cope with a burdensome immigration crisis, its only recourse being weak national institutions.
Euro membership has removed the traditional economic reset button that countries with weakening growth, including Italy, have often pushed: currency devaluation. But the euro zone’s wealthy, export-led north is unwilling to show the fiscal solidarity necessary to help Italy return to growth without the devaluation option, and its institutions are too weak to force the issue. The project for banking union is in limbo, and the tiny size and tight constraints of the €30 billion European Investment Stabilization Function unveiled last week indicate how far the euro zone is from any kind of pooling of fiscal risk.
Incentives
To be clear, there has been progress in Europe, and in Italy, since 2012. Spain, Portugal and Ireland have managed to haul themselves back to growth and stability. While Italy still labors under a government debt burden of 130% of GDP, it managed to auction €5.6 billion of bonds even in the grip of last week’s crisis. More than 12% of its bank loans were nonperforming at the end of Q3 2017, according to the ECB, but that was down from 16.6% a year earlier, after some record-breaking asset sales.
Nonetheless, much of this progress, and the lack of obvious systemic risk, relies on the current environment of growth at home and overseas, as the ECB acknowledged in its latest biannual Financial Stability Review. Structural reform of the euro zone has proven hard even during the past six years of relatively sunny weather. It will be much more difficult to fix the roof, or ignore the hole in it, when the economic rainclouds return.
Investors might take a couple of conclusions away from this. The first is that the systemic risk inherent in the structural shortcomings of the euro zone can lie dormant for a long time, but should not be ignored. The second is that Draghi and the ECB still have very strong incentives to err on the side of caution as they begin to think about tightening policy.
In many respects, Italy is the ultimate stress point for the euro zone and its political and economic future. The way this challenging situation of slow growth, political division and burdensome debt gets resolved will determine the long-term success of the euro zone, which, as a reminder, is actually the largest economy in the world. We all need to pay close attention.
Copyright © Neuberger Berman
