Eurozone debt crisis part II?

It’s been a rough few days for European bond markets after a resurgence of political disorder on the Continent. However, our head of asset allocation research, Edward Smith, argues that we are still a far cry from the dark days of the 2011 eurozone debt crisis.

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Europe is back to its old tricks. Just when you thought the Continent was settling down, two governments start disintegrating over a weekend.

Italian President Sergio Matarella has effectively shut down attempts by far right and left-wing parties to form a broad coalition. Instead he appointed a technocratic leader to guide the country. For all his good intentions, Mr Matarella’s actions are likely to stir up trouble in a country that feels suffocated by “elites” and European Union-enforced austerity. Mr Mattarella’s technocrat is likely to be ejected in a vote of no confidence and Italy is expected to return to the polls in July or September.

The upheaval flipped a switch in the Italian debt market. The 10-year yield has shot up above 3.0% in May, up from 1.78% on 30 April. Its two-year debt has also spiked, with even more venom: it got as high as 2.77% on Tuesday (it closed on Monday at 0.87%). Just two weeks ago, short-term Italian debt yields were negative.

But is this the eurozone debt crisis part II? So far the contagion is limited. The architecture of the Economic Monetary Union (the single currency and combined central banking system) is very different today compared to 2011. Numerous backstops have been implemented for countries that agree to play by the rules (the European Central Bank's ability to buy unlimited quantities of government bonds under the Outright Monetary Transactions programme, and the European Stability Mechanism).

They appear to be working: Spanish spreads are only a touch above their three-year average and Portuguese 10-year debt still yields about 50 basis points less than US Treasuries. Even Italian spreads over German debt are nowhere near the giddy heights reached seven years ago. High-yield corporate debt yields are a third of their 2011 levels and credit default swaps (a measure of credit risk) are still relatively cheap. Although the stock prices of European banks have reached a new low relative to their American counterparts, the average yield on BBB-rated bonds issued by financial companies is 2.75% compared to 25% during the eurozone debt crisis.

Long-term issues remain, however. If Italian parties don’t start to understand the depth of peril that a run on their debt would have, the effects could be significant for the country. However, I think the contagion risk for the economic bloc is low. Surrounding markets will probably get rocky in the short term, but soon right themselves.

Italians are fed up with austerity, blaming it for a much deeper-seated economic malaise. And their populist politicians have pandered to them.  Before the President vetoed its ministerial appointments, the 5 Star/La Lega left-wing/right-wing coalition was committed to a tremendous fiscal splurge, and called for a re-evaluation of the EU budget and the rules designed to prevent national governments from pursuing dangerously unsustainable fiscal policies. Thankfully, 5 Star no longer wants to leave the EU and La Lega has backed away from this too. We should also be thankful that both parties have dropped the call for the ECB to cancel €250bn of Italian government debt. Still, the more extreme fringe of La Lega has mooted engineering a financial crisis so that Italy can ‘legally’ create a new currency for themselves.

Although Italy’s government takes in more taxes than it pays out (excluding interest payments), a fiscal splurge of the magnitude planned by the prospective La Lega/5 Star coalition would quickly lead to some unsustainable arithmetic for its debt servicing. Worse, there is nothing in 5 star and La Lega’s plans to address Italy’s biggest problems: (i) woeful productivity; (ii) one of the most rapidly ageing workforces in Europe; (iii) a banking system still drowning in bad loans. And there’s a whole lot to make those problems worse. In fact they’re proposing to make it even harder for banks to repossess collateral, thereby likely requiring even further write-downs on outstanding bad debts, which are still an extraordinarily large amount of banks' total loan books.

The economic outlook for Italy is bleak. No one has the political capital to push for sorely needed reform. If La Lega and 5 Star are returned again, their policies would likely lead to a short-term boost to consumption, before spiralling interest rates bring the whole economy crashing back down to earth. Sure, the Italian political system does have checks and balances – the President can veto policies – but support for populism is strong. Italy has a small graduate population, a highly unionised workforce, terrible social benefits and a form of proportional representation – all attributes that increase the tendency for populism to take hold. This environment will inevitably lead to some vocal and heated clashes that the press is likely to leap on.

Expect more days like Monday and Tuesday when they hit the headlines, but focus on the wider picture and ask if the contagion is spreading. Spain’s government may be falling apart too, but with a very, very different result: the party in the ascendancy is the firmly pro-EU, pro-reform Ciudadanos with radical but centrist ideas. It’s a shame they’re not Italian. 

 

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