Brexit is not the only crisis in Europe

19 October 2018 | Markets and Economy


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Euro sign and map of Italy

Commentary by Vanguard Senior Economist Alexis Gray.

Ever since the Brexit referendum in June 2016, investor focus has firmly been fixed on what its implications will be for the UK and Europe. More recently, concerns have shifted to the potential impact on the global economy of the US and China trade war. With all this going on, there has been little time to worry about European politics.

But it is European and, more specifically, Italian politics, which has now come to the forefront. The rise of populism has been felt in a number of countries in recent years and Italy has been no exception, with the populist Five Star Movement emerging as the largest party in March’s elections. And even though they had to form a coalition government, it is this administration that is behind the current crisis.

Italy – no stranger to problems

Italy has had economic problems for many years, ranking among the countries with the largest debt (€2.2 trillion as at the end of 2017)1 and a double-digit unemployment rate since 2012. Its GDP currently stands at a level lower than in 2005. To add to its woes, the country has seen a huge influx of immigrants as well as years of austerity and budget caps. Therefore, it is perhaps unsurprising that in a survey late last year of all member countries, only around 45% of Italians thought the euro was good for their country.2

But now the eurozone’s third largest economy finds itself in a fresh political and economic crisis. By passing a budget that comes close to and may well end up breaking the EU’s fiscal rules, the government has sent yields on government bonds soaring. And with Italian banks still holding large amounts of these bonds, their shares have been sold off heavily, reversing what had been a good recovery in the sector. Encouragingly however, the country’s finance industry is better placed to weather a shock than it was a few years ago. So this latest banking crisis does not necessarily mean a banking system meltdown.

However, with 10-year government bond yields at a five-year high of 3.6%, financing costs for Italian companies will become more expensive, making them less competitive relative to their European counterparts. At the same time, there are concerns that the government is borrowing money that it will not be able to repay in the future, increasing the risk of default.

With Italian equity and bond markets having already underperformed over the last few years, this does not bode well for the near term.

Could Italy leave the euro?

Despite the unease in Italy and the calls for Italy’s own Brexit style referendum, we believe that a risk of it, or any other country, leaving the euro remains below 5% over the next five years. If such an event were to occur, it would put immense pressure on the euro and risk a complete break up, which would be bad not only for Europe, but for the global economy – imagine a global financial crisis 2.0. For this reason, we believe that all parties will do what is necessary to ensure the status quo.

What does this mean for investors?

While Italian markets have been underperforming, they make up a relatively small part of European and global benchmarks.3 So the impact of this underperformance on European or global portfolios has been minimal.

Therefore, despite certain risks, our view does not warrant a radically new investment strategy, as concerns about the euro are likely already reflected in asset prices. Moreover, geopolitical risks exist across regions and are difficult to avoid. We therefore encourage investors to remain disciplined and globally diversified.

1 Source: Macrobond and the Bank of International Settlements, 2017.

2 The survey was conducted in October 2017 by TNS Political & Social network in the euro area’s 19 member states. Some 17,547 respondents from various social and demographic groups were interviewed by telephone on behalf of the European Commission, Directorate-General for Economic and Financial Affairs. Source: European Commission Eurobarometer, October 2017.

3 Italy makes up 5.3% of the FTSE Developed Europe ex UK Index and 0.8% of the FSTE Global All Cap Index. It makes up 4.1% of the Bloomberg Barclays Global Aggregate Bond Index. Source: FTSE Russell and Bloomberg. Data as at 31.08.2018.

Alexis GrayAlexis Gray
Vanguard senior economist

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