How Italy could still knock the Euro­zone off tar­get

What are the po­ten­tial im­pli­ca­tions for mar­kets in Europe and be­yond?

Shares - - CONTENTS - By Russ Mould, in­vest­ment di­rec­tor, AJ Bell

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:

1. Why are mar­kets as un­happy as the EU’s bean coun­ters?

2. How can in­vestors tell?

3. What are the po­ten­tial im­pli­ca­tions for mar­kets in Europe and pos­si­bly be­yond?

BUD­GET SHIFT

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.

Source: Thom­son Reuters Datas­tream

ITAL­IAN GOV­ERN­MENT BOND YIELDS ARE RIS­ING AGAIN

Source: Thom­son Reuters Datas­tream

ITAL­IAN AND EURO­PEAN BANK STOCKS ARE PER­FORM­ING POORLY

Source: Euro­pean Cen­tral Bank, € bil­lions

IM­BAL­ANCES ARE GROW­ING WITHIN THE EU’S TAR­GET-2 SYS­TEM

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