The Italian situation is clearly a big concern for Europe. The obvious fear is that we could have another Greece / Varoufakis moment coming, but Italy is a lot bigger than Greece.
Rewinding the clock back to the first half of 2015, Greece’s rogue Finance Minister Varoufakis, as part of the newly elected Syriza-led government, claimed that Greece’s debt level was unsustainable and the European Union would have to accept a debt write-off to restore the country’s solvency. The argument today is that Italy also has too much debt (the case could be made that this is true of most of the western world), while a leaked ‘draft’ government programme from Italy’s populist parties included a request for a €250 billion write-off as well, although this was subsequently dropped.
What Varoufakis said about too much debt was arguably correct, but to think it could just be written off was an error. The EU has been working with Italy, Greece and anyone else to help solve their debt problems, and will continue to compromise, but only as long as the countries abide by the rules.
The ‘populist’ parties in Italy, the left-leaning Five Star Movement and the right-leaning League, won the biggest proportion of votes in the country’s March elections, while the incumbent parties did poorly. It was not originally thought that these protest parties would be able to form a government. But when they did, eventually, unite – around a shared dislike of other parties, the (perceived) corruption of previous governments, the euro, and being forced to follow the economic rules set down by a dominant Germany – the choice of a new finance minister, Paolo Savona, was blocked by President Sergio Mattarella. So what was originally a mess turned into something that could well become even messier.
The problem with cheap debt
To some extent, the populists may have a good point – one that was highlighted by David Willetts, a previous Conservative government cabinet minister in the UK. A large part of today’s wealth can be attributed to the fact that previous governments globally, from Japan and Italy to the US and the UK, have responded to repeated crises by throwing money at them. Debt has been cheap, and still is in most countries, so why not borrow more to invest in education, healthcare, elderly care, pensions and infrastructure? There does, however, come a point where debt becomes unsustainably high, and within the framework of a single currency the ’easy’ route of devaluation is not available. This, incidentally, was one reason why the Conservative government of the late 1980s and early 1990s chose to enter into the Exchange Rate Mechanism (ERM), so that future governments would be forced to run the economy in a more responsible way. Italy cannot simply devalue its way past this crisis, and devaluation would realistically not solve the debt problem anyway.
It is easy for the populists to say that Italy has been lured into a restrictive and inflexible economic cage with the euro, and it is time to get out. But getting out will not solve the debt problem and could potentially make it worse, as the cost of debt would rise even more. The spread of Italian 10 year debt is now over 270 basis points (bps) – more than 100bps higher than a few weeks ago. While all more rational financial commentators in Europe are right to make this point, the populists in Italy are leveraging the inflated spread as a badge of honour; proof of the ‘injury’ inflicted on the country by external forces. It is not necessarily their fault that the country’s debt is so high in the first place. Five Star and the League were not part of the political establishment that overspent (or over-borrowed). But this is an issue they cannot continue to ignore, and they will need to work with their European partners to find a solution.
So what happens next?
I think it quite likely that there will be new elections in Italy in the autumn – although tempers might have eased if a caretaker government can hang onto some kind of power for long enough for the economic recovery, which started about two years ago, to become more established (March 2019 perhaps?). It would also help if the European Central Bank (ECB) and European economic rule-makers could persuade Germany to take an easier line with Italy, which needs help across a range of matters, from navigating the EU’s strict and inflexible economic rules to dealing with the migrant crisis.
In the meantime, investors will most likely continue to shun Italian equities, and Europe will once again become a focus for bad press, diverting attention away from what is (or at least was) a reasonable and sustainable recovery, both in economic terms and corporate earnings. The worst possible case, where Italy crashes out of the euro, is not a desired outcome for the populists. There are plenty of top-quality engineering and manufacturing companies in Italy that are thriving, but there are also plenty of people who are fed up with the country’s current situation, and the apparent inflexibility of the rule book when it comes to dealing with their European partners.
While we may be facing another (avoidable) crisis for the euro, I do not expect the single currency to fall apart. The European Commission and the ECB will continue to enforce the rules, while also doing their very best behind the scenes to help Italy through this latest predicament.
These are the manager’s views at the time of writing, on 29 May 2018. They may not reflect those of other managers at Janus Henderson Investors.
Anything non-factual in nature is an opinion of the author, and opinions are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use.