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Aon Retirement and Investment Blog

AA View: will an Italian crisis turn in to a Euro-Area one?

Executive Summary
Italy has been plunged in to financial and political chaos over the last fortnight with new elections, possibly in September, now probable. The Italian President’s decision on Sunday to reject Paolo Savona (an economics professor known for his view that Italy needs a “plan B” ready should Italy decide to leave membership of the Euro-Area) as finance minister, prompted outrage from the coalition of the Five Star Movement (known by the acronym M5S) and the Northern League (Lega Norda, in Italian, and known by the acronym, LN). They had last week proposed Savona alongside Giuseppe Conte (an obscure member of the M5S) as prime minister last week. President Sergio Mattarella has appointed an interim technocratic government but markets are fearful that post new elections the eurosceptic parties could be even stronger.

Our key views are:

  • An Italian exit of the euro would be a far bigger shock to financial and global markets than Brexit or the Greek default. Whilst the chances of such an event remain low, it is a tail risk that needs to be carefully monitored.
  • We believe that markets don’t necessarily react efficiently to rising tensions, and this creates opportunities for our buy rated managers.
  • We argue that spreads on Italian bonds have widened too much, at least relative to other European spreads. However, they are also likely to remain choppy for some time. Opportunities in both peripheral debt markets (including private and municipal) will likely present themselves over the coming months and weeks.
  • Italy is likely to be the main risk for the Euro-Area for the next year or so, but it isn’t the only longer-term risk. We discuss how euro break-up risk could come from a variety of different sources in the future.
How did we end up here?
Although the March Italian election (see our previous note) resulted in a hung Parliament, analysts argued that the most likely scenario would be a “grand coalition” with the biggest single party, M5S, at the centre of it, and until just over two weeks ago markets were sanguine about these prospects.

However, on Monday 21st May 2018, Giuseppe Conte, a relatively unknown politician in the M5S was nominated by a coalition of M5S and the LN, despite these parties being at opposite ends of the political spectrum. M5S has won support from traditionally left-wing voters. LN is a nationalist party which had advocated autonomy for the richer northern part of the country. At the election, LN ended up being the largest party in the centre-right coalition; a group which had previously been led by former PM Silvio Berlusconi’s Forza Italia party. Both parties have been skeptical about Europe and concerned about the impacts of immigration but otherwise had little in common. 

The decision by the Italian President, Sergio Mattarella, to block the coalition’s choice of Savona as finance minister was a surprise, rather than accept a compromise candidate. In turn, M5S and LN withdrew their proposed government and President Mattarella then nominated a former IMF economist Cottarelli to form a government. 

Polls have suggested that support for the Northern League has increased and markets fear that although a eurosceptic government has been postponed for now, a future M5S-LN government will be far stronger. We believe it is unlikely that the interim government will survive a confidence vote. This will lead to the dissolution of Parliament and after 60 days fresh elections (i.e. in our view this will likely be September or October).

As many commentators have pointed out, Italy could be “too big to fail but too big to save”: Italian public sector debt-to-GDP, at 131%, is smaller than Greece’s (180%) but its economy is ten times larger. Moreover, its bond market is far more important and, indeed, is the largest in the Euro-Area. A government which ignores EU fiscal rules, risks putting Italy on a collision course with the European Commission. In our view Italy crashing out of the Euro-Area remains a low probability event but that risk is being re-priced.

According to the latest Eurobarometer survey (a survey commissioned by the European Commission), whilst Italy is the most euro-sceptic of euro members, more Italians favour staying in the European Union than leaving (the rules around membership of the euro prevent leaving one without the other). The chance therefore of Italy leaving the euro (variously called “Ital-exit”, “Ita-leave”) still seems remote. M5S in particular seemed to soften in stance on the euro, reflecting the views of its voter-base.

Although they might not set out to leave the euro, M5S and LN's policies are inconsistent with remaining in it. Whilst all the political parties proposed fiscal programmes which are inconsistent with the EU’s fiscal rules, LN's proposal of a flat tax of 20% and M5S’s desire for a universal basic income, are particularly expensive. Estimates of the impact on the deficit range from -4% to -7% of GDP. The EU’s Fiscal Stability Treaty, signed back in 2012, requires that the General Budget Deficit cannot exceed 3% of GDP, and the structural deficit (the deficit after adjusting for the economic cycle) cannot exceed 0.5% of GDP. Furthermore, with public debt above 60%, the “debt break rule” requires bringing the debt-to-GDP ratio down over time. 

Whilst markets believed that the mainstream parties would bow to pressure from the European Commission if budget deficits increased too much, the concern is that, a M5S and LN coalition would contemplate leaving the euro if it was necessary to achieve their broader aims.

There were also more radical proposals such as unilaterally cancelling Italian debt owned by the ECB and the introduction of what would effectively be a parallel currency (the government would pay suppliers with mini-bonds which could be sold and used to pay tax bills but wouldn’t pay a coupon). The parties had gone quiet on these ideas. However, it is possible these will be dug-up again if they wish to strike a more confrontational position with the European Commission. Whilst M5S and LN have pledged to renegotiate the Fiscal Stability treaty, there is little appetite in northern countries such as Germany to loosen restrictions. Support for cancelling ECB holdings of sovereign debt is likely even lower.

Why have markets only taken fright recently?
We don’t think markets have been reacting particularly efficiently to Italian political developments. The market was surprisingly sanguine about the election result and attributed this in part to the bad news largely being priced in and favourable developments in Germany. However, spreads tightened over the following weeks suggesting the markets were relaxed about an M5S-led government.

As the chart above shows, over the last week the spread between two year Italian government bonds (BTPs) and German government bonds (bunds) has moved more than the 10 year spread. We think the chances of Italy defaulting or exiting within two years are trivial. Italy’s fiscal framework is embedded in the constitution and radical changes would take some time to implement, any subsequent confrontation between the EU and the Italian government would likely last years before exit. Higher default risk might sometimes justify a flattening or even inversion of yield curves. If investors think an event might be imminent then bonds should trade at a similar proportion of par and this will impact the yield to maturity on shorter dated bonds more than longer dated bonds. However, since we think the annualised probability of default is lower of two years than four we don't think this is reasonable. 

Markets which are effectively pricing euro-area break up risk also seem relatively sanguine at the moment. The difference between French Sovereign CDS (Credit Default Swaps) written under ISDA (International Swap and Derivatives Association) 2014 rules and 2003 rules remains at about 11 bps, similar to the levels it has been for most of this year. Under the 2014 rules if the currency in which investors are repaid is different to the original currency then this counts as a default. The difference in the price of the two contracts can be thought of as the price for insurance on the tail risk of complete Euro-Area break-up. This 13 bps level contrasts (as at 29th May 2018) with the 2017 peak of 35 bps, reached during the run-up towards the French Presidential elections.

Over the last week French government bond spreads versus EONIA (European overnight interest rates) have narrowed out to the 15 year tenor, and widened only very slightly at longer dated tenors. This suggests markets are relaxed about the impact on French bonds, which have in recent years often seen spreads widen when Euro-Area tensions have risen. Spreads on Spanish bonds versus EONIA have widened although the most impacted tenors are at 3 to 4 years. 

Are Italian BTPs set to outperform?? 

We think that the most likely scenario is that the LN and M5S are sufficiently pragmatic that, if bond markets put pressure on them, they will rein back fiscal plans. Whilst we don’t know if today’s spreads will mark a high for the market, our base case scenario is that hold-to-maturity investors will earn higher returns in Italian BTPs than they will in German Bunds as an exit from the Euro-Area or default are still unlikely within the next 10 years. However, although these risks are low, an eventual downgrade of Italian debt from BBB to speculative grade by the ratings agencies is entirely plausible if a MS5-LN coalition come to power and ploughs ahead with their fiscal plans.

If all the main rating agencies were to downgrade Italy to a speculative-grade rating then the bonds would no longer be eligible for the asset purchase programme; removing a significant support for Italian bond prices. 

Investors would therefore need to be prepared to sit tight at potentially higher rates and a downgrade. When a Socialist Government came to power in 2015 in Portugal, bond markets took fright at the plans for higher pensions and an end to austerity. Threats of fines from the European Commission, and the possibility of being downgraded to speculative by DBRS (the ratings agency, and the only major one to rate Portugal investment grade) also caused spreads to blow out. However, in the end, the Government pursued a relatively modest cause with promises being funded by tax hikes elsewhere. Spreads though remained high and volatile for much of the next 2 years before the recovery in the Portuguese economy led to higher tax revenues and reduced deficits, and broke below pre-election levels. This suggests that Italian BTP investors might have to wait for a while before spreads go back towards their lows.

Our preferred way to play European rates opportunity set is through active managers. Spikes in spreads can be short-lived: a nimble active manager can take advantage of short-term dislocations in markets as well as being able to judge which securities are furthest from fair value. We think that the European rates space is relatively inefficient and therefore will provide lots of opportunities for our buy-rated managers.

Does this create broader risks for markets?
We think that the most likely scenario is that a M5S/LN government will eventually come to power. When it does so it we suspect it will play hard ball with the Commission and their European partners. Further Italian-German bond spread widening is therefore definitely possible. However, we doubt that, by itself, it will have significant impacts outside Italy. For Europe to go wrong we think that there will need to be more than just a Eurosceptic coalition in Italy. We think that the Italian public is sufficiently committed to the euro that “Ita-leave” will be avoided.

However, that doesn’t mean we should be complacent about Euro-Area risks with potential shocks originating further afield from Italy. Whilst we don’t think that Catalonian independence from Spain is likely, a break-up would be extremely disruptive, especially if a new, independent Catalonia was forced out of the euro. A euro-sceptic President in France can also not be ruled out. The risk is increased because the two-round system used could result in the run-off candidates being from the far left and right. The rise in the right-wing German party Alternative for Deutschland, something which was unthinkable a few years ago, shows how all countries can be vulnerable to a shifting political landscape.

For the moment, however, these risks seem a long way-off. The latest Eurobarometer survey suggests support for membership of the European Union is increasing across the Euro-Area. However, given the strong recovery and improving consumer sentiment, this is not a surprise. Support is more likely to be challenged when economic conditions become tougher. Whilst we’re still positive on the Euro-Area macro outlook, we have also noted previously that the US economic expansion is getting “long in the tooth”. If the US was to go in to recession (perhaps after the positive fiscal impulse fades in 2020), then it might be difficult for Europe to continue to still grow and tensions will start to rise again.

Derry Pickford is a Principal on Aon s Global Asset Allocation team, and is based in London, UK.

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