How Italy could still knock the Eurozone off target
The old saying that ‘markets like to climb a wall of worry’ is getting a good work-out this autumn. As if a rising oil price, a strong dollar, tighter monetary policy in the US, emerging market debt crises and the Brexit negotiations were not enough for investors to ponder, you can now add Italy to the list.
After three months of haggling, March’s general election eventually led to the formation of a coalition government in Rome. And given their victory on an anti-austerity ticket, no-one should be surprised that the two leading Italian parties, the right-wing, separatist Northern League and the anti-establishment Five Star Movement, are now looking to push through a more expansive Budget, even if Brussels and the EU rule-makers are unhappy about it.
This begs three questions:
– Why are markets as unhappy as the EU’s bean counters?
– How can investors tell?
– What are the potential implications for markets in Europe and possibly beyond?
The Italian government has drawn up a Budget which has three key thrusts, all designed to boost growth and tackle unemployment, especially among the young. As a result, Italy’s projected annual budget deficit for 2019 will be 2.4% of GDP, rather than the 0.8% agreed with the European Commission in 2017. Plans for a balanced budget by 2021 have also been scrapped.
Brussels seems unamused, arguing that the plans are not compatible with the prior agreement and wider European stability. Italy already has an aggregate debt-to-GDP figure of 130% and it is home to the world’s third-biggest government bond market. It is too big to bail out.
The Italians may be entitled to feel miffed, given that France is forecasting an annual 2.8% deficit for 2019 and Spain 2.7% while in America the Trump tax cuts are being lauded as a key driver of growth even if they will take the annual budget overspend to 5% of GDP.
WATCH THE TARGET
The markets seem as unimpressed as the EU authorities and this can be seen in two ways.
The first is a sell-off in Italian government bonds, or BTPs. The yield on the 10-year paper has rocketed to 3.58% as supply is about to increase just as the European Central Bank (ECB) prepares to stop its quantitative easing programme in December, knocking a potential buyer out of the equation.
The second is capital flight from Italy. This can be monitored via the Trans-European Automated Real-time Gross Settlement Express Transfer (or Target-2) mechanism.
In essence the system is there to help balance trade flows but it also reflects capital flows.
Bears and sceptics of the single currency in particular assert that Target-2 flows merely highlight huge capital flight from the south. The good news is that eight Eurozone members are now in credit (up from five a year ago) – Germany, Luxembourg, the Netherlands, Finland, Ireland, Slovakia, Cyprus and Malta – and Greece’s deficit is still shrinking.
The bad news is that Germany’s positive balance is higher still and it looks like money is leaking out of Spain and Italy. If this trend continues through 2019 – and the data is released with a two-to-three-month lag – it could in turn imply the Eurozone edifice is coming under increasing strain, with Germany and the select number of other creditors bankrolling the rest.
BANKS BACK IN THE SPOTLIGHT
Target-2 suggests Italy’s budget battle could have continent-wide implications, although any reversal of flows back south would be a positive sign.
But the most pressing concerns are strictly Italian. The rise in BTP yields increases the cost of funding for Italian banks and could restrict their ability to lend. Moreover, falling bond prices erode Italian banks’ capital, as they are huge owners of Italian government debt.
According to analysis from the Bank of International Settlements, Italian government debt represents nearly one-fifth of Italian banks’ total assets, more than 140% of the regulatory Tier 1 capital at leading lenders Unicredit, Intesa Sanpaolo and more than 200% of Monte dei Paschi di Siena’s Tier 1 reserves.
If bond prices keep falling, Italy’s banks will get weaker; and if its banks and economy get weaker, then its bonds could keep falling, in the very doom loop that the ECB launched QE to avoid. And if Italy’s banks wobble, the markets may start looking at who else is lending them money, if they are not already – the Stoxx Europe 600 banks index is already doing badly.
None of these concerns have to be borne out. Italy’s finance minister, Giovanni Tria, is arguing that the annual deficit will start to shrink as economic growth accelerates (the same argument put forward by the Trump administration in the US).
But investors with exposure to Europe or the banking sector, via their chosen funds, may need to keep an eye on events in Rome over the coming weeks and months, just in case.
Russ Mould, investment director, AJ Bell