In the past two weeks investors have come, belatedly, to recognize the negative implications of the election of a populist government in Italy, the first such government in Western Europe. The possibility of a government collapse in Spain as a result of the main opposition party’s call for a vote of no confidence added to investor concerns last week. Leading indicators of Eurozone business activity showed that economic growth in May, while still characterized by HIS Markit as “robust,” had slowed for the fourth month in a row. Bond prices and financial stocks fell sharply, though by no means as much as they did during the Eurozone crisis.
The Italian election on March 4 resulted in two radical populist parties seeking to form a coalition government. While both are called “populist,” they have conflicting policies, so it isn’t surprising that their efforts to form a government were difficult, and ultimately failed. The Five Star Movement (M5S), which says it transcends the left-right divisions, called for a universal basic income of $920 a month, implying a huge increase in government outlays. The Northern League is a far-right party that has called for a flat tax rate of 15% and xenophobic actions against refugees. It would like to see heavy spending on infrastructure, which is opposed by the environmentalists in M5S. Both parties wish to roll back pension reforms and other reforms that were directed at boosting competitiveness. Both are strongly Eurosceptic and show little inclination to be bound by European Union rules and regulations. Both call for scrapping sanctions against Russia.
Last Monday the two parties decided on a compromise candidate for Prime Minister, Giuseppe Conte, a law professor, whoon Wednesday was given a mandate to form a government. They then turned to putting together a cabinet. Their choice for Finance Minister, Paolo Savona, an 81-year-old arch Eurosceptic economist who also is an opponent of austerity programs, encountered strong opposition from investors and most importantly from Italy’s president, Sergio Mattarella.
Italy’s president has the right under Italian law to reject the appointment of a cabinet member and he did block the appointment of SavonaSunday night. Conte then gave up his efforts to form a government. Mattarella asked Carlo Cottarelli, a former IMF economist, to run a technocratic (caretaker) government. Mr. Cottarelli said he would like to receive parliament’s backing for him to serve through the end of the year followed by a new election in January. That would permit him to propose next year’s budget. However, it looks more likely he will not gather sufficient support, which would imply new elections as early as September.
Relief Then Fear
Monday there was first relief in European governments and in financial markets that a populist government in Italy had been prevented but this reaction soon was overtaken by the fear that the populist parties could emerge strengthened by these events if there is a new election. The drama thus continues.
Before the weekend, Moody’s had already seen enough to place Italy’s credit rating on review for a downgrade. The agency cites a “significant risk of a material weakening” in Italy’s fiscal situation and of a reversal of recent reforms. Note that Italy’s public debt at the end of 2017 was 132% of GDP.
The situation in Spain is less dire. Prime Minister Mariano Rajoy, whose minority government has been hurt by a campaign finance scandal, faces a confidence vote later this week and may have to call snap elections. Also, Catalonia has a new regional government that looks likely to be confrontational in pressing its separatist agenda. Markets do not like uncertainty. However, it is important to note that Spain has made great progress in recent years in strengthening its fiscal position and addressing problems in the banking sector. This progress does not appear to be threatened.
Economic expansion continues in the Eurozone but at a more moderate pace than at the beginning of the year. The increase in the HIS Markit Flash Eurozone Composite Purchasing Manager’ Index (PMI) for May was the weakest in one-and-a-half years. The final PMIs for April showed output growth for Italy at a 15-month low, for Spain at a 4-month low, and for Germany at 19-month low, while for France it was at a 2-month high. Understandably, business optimism in the Eurozone is reported to have weakened. While a number of special factors have affected the data, including extreme weather, the timing of Easter and of holidays in May, and strikes, underlying momentum has clearly slowed.
There has been a positive development in Europe worth noting. European Union finance ministers have agreed on a deal that will toughen regulation of European banks and reduce risk in the banking system, a step urged strongly by Germany and its Northern European neighbors. This deal is regarded as a necessary step to further Eurozone reforms. The agreement must be discussed with the European Parliament before it is formally adopted. There are concerns that Italy, which abstained from the agreement, will try to alter the text.
The market reaction to recent European developments has been sharpest in the bond markets. A sell-off of Italian debt resulted in a spread of some 130 basis points in the yield of Italian two-year bonds above their German equivalent during the last two weeks through last Friday. This development was due to both a sharp rise in Italian bond yields and a decline in German yields as the German bond market benefited from a flight to safety. On Monday the fear that Italy’s populist parties would win more votes in a new election caused the yield on Italian 2-year bonds to spike up again to 0.981% and then settle close to 0.9%.
The equity market reaction thus far has been greatest in Italy. The iShares MSCI Italy Capped ETF, (NYSE:EWI), lost 4.28% over the past week and 9.41% over the past 30 days through last Friday.Monday the US markets were closed but the FTSE MIB index for Italian equities fell by 2.1%. The Spanish market fared somewhat better. The iShares MSCI Spain Capped ETF, (NYSE:EWP), posted losses of 3.9% last week and 5.08% over the past thirty days through last Friday.
The overall effect on Eurozone equities had been modest until today, May 29. The iShares MSCI Eurozone ETF, (NYSE:EZU), eased only 1.96% over the past week and just 0.32% over the past 30 days. However, today the turmoil in Italy is disturbing global markets. Dow Jones Stoxx 600 dropped 1.3% with financials down 3%. Italian stocks tumbled another 3% and Spain fell 2.5%. The yield on Italian two-year bonds rose another 140 bp to 2.24%. The evolving situation, particularly in Italy, requires careful monitoring, because systemic risks in the Eurozone appear to have increased.