- The economic and political crisis in Turkey has spread across emerging markets and sparked fears of global contagion
- Italy is particularly vulnerable and could be the conduit for broader global market pressure
- Italy’s populist government has a combative stance toward EU policies as evidenced by its consideration of spending increases that triggered a sell-off in Italian sovereign bonds and pressured Italy’s bank stocks
Italy is a large economy with a debt of more than $2.5 trillion, and if a crisis were to unfold there, it would have far-reaching effects — greater than the impact of the crisis in Turkey today or in Greece during 2012.
We are closely watching Italian political developments, which we believe pose a threat to Italian assets and potentially to the integrity of the European Union (EU). The situation in Italy is precarious for a combination of reasons: the size of the economy ($2 trillion GDP, third largest in the EU), the burden of government debt (130% of GDP), a slow economic growth rate (less than 1% annually since 2011), and the high rate of ownership of government debt by domestic banks.
Italian bond yields are key
The ECB’s accommodative monetary policy has helped to support Italian bond yields in recent years. The populist coalition, elected in May, is contemplating an increase in government spending, which would push debt-to-GDP further into dangerous territory. If bond investors were to lose confidence in Italian debt, resulting in a sustained spike in interest rates, Italian banks would be squeezed, and the economy would tip into recession, we believe. Given the high government leverage, we feel that a debt spiral would be difficult to avoid, pressuring the entirety of the EU and creating turmoil globally. The markets are on alert, as evidenced by the initial rise in Italian bond yields this summer and the nearly 20% sell-off in Italian equities.
Politics point to a policy standoff
Italian assets initially sold off in May and June on concerns for the new populist coalition, but we believe September will be the first real test of the coalition’s capacity to deliver on policy promises and approve a budget. This looks like a substantial challenge in the face of Italian government rules that require a balanced budget as well as constraints required by the European Commission (the EU’s executive body). The tragic Genoa bridge collapse in August has been seized by populist members of the coalition as another reason for pushing back on EU budgetary limits and austerity in general. In addition, the right-wing populists are refuting European immigration policy at a time when Turkey is facing an economic crisis and might become a less hospitable place for the millions of displaced immigrants there. Below are more details on our specific concerns surrounding Italy’s economic and political situation.
1) The populist program of spending
The two major parties that have combined to form Italy’s populist coalition government — the left-wing Five Star Movement and the right-wing Lega party — are proposing policies that imply fiscal expansion through a flat tax reform, pension reforms, and minimum income guarantees. We find it difficult to see how the government, in the face of dwindling economic growth and budget surpluses, can manage this without expanding the nation’s debt-to-GDP position. Their “fully fledged” policies would imply a widening of Italy’s government deficit to 3% of GDP.
2) Constitutional issues
An increase in the deficit to 2% of GDP would contravene both the Italian constitution and European Commission requirements. Given these factors, the populist coalition will have to decide either to dilute the policy to achieve a budget deficit closer to 2% of GDP or to fight for the policy that got them elected. Recent rhetoric from the populist coalition has not been supportive of a compromise, with the finance minister going so far as to suggest a change to the constitution. However, a constitutional change is unlikely, as it is more in keeping with Italian political precedent to find a muddle-through compromise.
3) Immigration risk
A central policy for the Lega is opposition to immigration. Should Turkey reverse course on its current immigration policy and allow some of the 3.5 million displaced migrants beyond its borders into Europe, then Greece and Italy would be the first to feel the impact. This possibility is only likely to bolster the populist coalition, particularly the Lega’s combative discussion and disagreement with the European Union. Recent poll ratings for the coalition have risen due in part to the leadership’s tough stance on immigration. Further disagreement with the European Union is not helpful for sovereign risk or stability in the region, as witnessed during the market volatility of May and August.
4) Credit rating agency concerns may exacerbate the situation
A fiscal expansion and further increase in the government debt-to-GDP ratio will likely place downward pressure on sovereign ratings ahead of discussions with the European Union. Already, the outcome of recent sovereign bond sales has been underwhelming. Credit rating agency Fitch recently cut its outlook on Italy’s government debt as well as on five Italian banks to “negative” from “stable” because of the degree of political uncertainty presented by policy differences. Moody’s is currently reviewing Italian debt for a potential downgrade, and S&P is due for an update in late October.
5) Manifestation of risk through BTP and Italian banks
Italian sovereign spreads continue to rise relative to European (German bund) peers. The risk of a further widening of spreads amid budget discussions is real. We expect this risk to manifest in the share price of Italian banks as a bellwether for the market. The banks hold high levels of BTPs (inflation-linked Italian government securities) in their liquidity portfolios. These risks would hit Italian banks just as they were finally getting back on the right track. Recent asset sales by Italian banks have fortified their balance sheets, with capital levels now well in excess of historical levels, putting them in a much better place to manage the risk.
Although Italian and European equity markets have already begun to price in some of these risks, we have concerns about the impact to global markets if the situation were to deteriorate. As active managers, we are consistently monitoring the situation and are ready to adjust portfolio exposures as the situation develops. We believe the consistent dialogue across different members of the global equity team is, as always, an asset.