Miton - Eurozone crisis all over again?

Whilst in the UK we tend to focus on the increasingly tense Brexit negotiations, in Europe the focus is equally on events unfolding in Italy.

Italy’s populist coalition comprises a nationalist right wing party and a left wing party whose common ground seems to be largely an anti-establishment bias. The issue at the moment is that the coalition must submit a budget which, anywhere else, would be a normal and uncontroversial event.

However, Italy is different in two important aspects. Firstly, it is part of the Eurozone and members must get their budgets approved by the European commission to ensure that members do not cheat on the commission’s rules around the size of deficits. Secondly, Italy is the largest issuer of Euro government bonds, with slightly more debt than France and Germany, each of which have bigger economies. So, unlike Greece, Italy really matters.

The current budget proposal, leading to a deficit of 2.4% of GDP, has been heavily criticised by other Eurozone finance ministers and the bond market has reacted very negatively, with the yield on Italian ten year government bonds now 3% above the German equivalent. The bond market had been hoping that debt to GDP would start to fall in Italy, rather than rise further.

The big question for markets is how this might play out. Quite clearly, Italy needs to be pursuing some economic stimulation, at the very least for the government to meet some of its election promises but also enhanced growth would enable Italy to better service its debt in the long-term. However, the European commission can be quite inflexible when it comes to its rules. For example, Spain and Ireland suffered greatly pursuing austerity to drag themselves out of recession and might feel it unfair that Italy can follow a more benign path.

At this level it seems like a huge stand-off, as the European commission cannot be seen to cave in on its rules and the bond market clearly doesn’t want to see Italy’s debt burden rise further. On the other hand, Italy’s government needs to be seen to be strong and effective and has hinted at leaving the Eurozone and the EU. In a post Brexit world, this would be a significant further setback for the whole project. At the same time as being a major debt issuer, the falls in Italy’s bonds present significant issues for the European banking system, hence the recent big falls in their share prices.

It seems to us that the classic ‘European solution’ is the most likely outcome, with a huge compromise which makes it look like both sides have achieved their aim, while nothing material changes. Italy continues to run a deficit, while promising reductions in the future, and the commission gives them a temporary free pass, as Italy has a much stronger negotiating position than Greece did.

All this assumes that Italy’s coalition government stays in power, as governments do not tend to last long in Italy. This must be on the commission’s mind: a temporary compromise, pending the arrival of more pro-European politicians to negotiate with. This perhaps partly explains the strong stance from the EU, which must in many ways be designed to worry the Italian electorate as much as its government.

We feel a resolution which involves kicking the can down the road is inevitable, though it’s not to say the news flow will not get worse before it gets better. We are still avoiding European bank equity although we have taken a small position in Italian government bonds. As a resolution becomes clearer, we may look to reintroduce a position in the banks.

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