During quieter news periods, market volatility can increase as company information is replaced with speculation on trade wars, tax policies that may or may not pass and who will win the next election. Often these matters are not trivial and can impact upon companies. The problem is that we are usually dealing in speculation and fear of what may happen, and markets hate fear. Many times, the reality of what eventuates looks vastly different to what was feared or hoped.
This is playing out at the moment in regards to the political situation in Italy. You may recall that the Italians went to the polls just a few months ago in early March and that the Five Star Party (anti-establishment) won 33% of the vote and the League Party (right-wing) won 17%. Neither party won enough votes to form a government in their own right and therefore after months of discussions they looked to form a coalition government. The problem for the financial markets is that both parties are Euro sceptics and have openly talked about leaving the European Monetary Union.
Under the Italian constitution, the President is required to accept the new government and over the weekend, the President – Sergio Mattarella, refused to approve the proposed finance minister. This refusal quickly led to the abandonment of the coalition government and leaves Italy without a ruling government. In this situation the President usually appoints a technocratic government who will run the country until new elections are called.
The proposed technocrat, Mr Carlo Cottarelli is hugely unpopular and is known as ‘Mr Scissors’ thanks to his prior spending cuts. His nomination needs to be approved by parliament and that seems highly unlikely which means that new elections will need to be announced much sooner than previously proposed. The earliest date would be in July; however, August seems a likely outcome.
Election turmoil in Italy is nothing new, they have had 65 different governments since 1945 or about one every year. Why then the interest and concern about this political impasse? The reason is the increase in popularity of both the Five Star and League parties. Both parties have their differences but at their core they are anti-establishment, anti-Brussels (European Union) and anti the common currency. The current fear is that any new elections will simply increase the popularity of both parties and will be seen as a referendum on Italy remaining a member of the European Union.
Financial markets care about what happens to Italy as it is the third largest economy in the Union and one of the biggest debt issuers on the continent. Its debt is running at 130% of GDP and unemployment is still high, especially amongst those under 25.
The fear argument runs along the lines that either party will gain sufficient votes to form a majority and will push for an exit from the Union and the Euro. The spill over from that will be increased concern over banks who hold Italian debt (mainly Italian banks at this point) and their viability. There would likely be a credit crunch in Italy, a slowdown in the economy and a dramatic pick up in inflation as it moved away from the Euro and back to the Lira. Any such moves would see a rush back to defensive assets, such as US treasuries and German bunds, meaning interest rates in those two areas would fall and the US dollar would rise. Both the US Federal Reserve and the European Central Bank would likely delay interest rate increases until markets settled.
Markets would also start to refocus their attention on Greece, the habitual bad guy in European finances, and the likes of Spain with its recent Catalonian issues and a Prime Minister facing a vote of no confidence, and Portugal. In this environment, investor sentiment would shift dramatically to a ‘risk off’ world and equity markets globally would start to trend back down.
The impact of these fears is already starting to play out in global markets. We have seen the US and Germany 10-year bond rates fall back from recent highs. Italy’s equity market has fallen just over 13% in the last month and many of its banks have fallen by more than that. Italy’s 10-year bond rate has also risen to a high of 3.43% and rates in Spain, Greece and Portugal have also moved higher.
While the impact on Italian markets has been large given the short time period, we are yet to see any significant moves in other markets. Yes, Italian rates have moved higher but I hardly see an interest rate of 3.43% on 10-year bonds bringing down an economy. If rates head north of 7% then I will be paying a lot more attention.
Interestingly, I saw an article on a US newswire this morning with a heading of “Dow slumps 400 points on Italian worries”. Many of you will know that I hate this style of lazy journalism, it is simply meant to catch your attention. To put this in perspective consider that the Dow Jones is representative of only 30 of the biggest stocks and the 400-point move is just 1.58%. A move of that magnitude is not uncommon and occurs regularly. Where is the headline that reads that the Dow is just 1.8% down from the start of the year or that it is up 14.8% over a full year or up 10.3% per annum over the last 5 years?
As investors, the bigger question we need to focus on at the moment is could this political impasse blow up into something much larger? I think the answer is yes it could, however the chances are somewhat remote at this point. The recent moves in Italian interest rates and equity markets are a warning to Italian voters – continue down this path and look for an exit; then expect significantly more financial pain.
You may recall that the Syriza party in Greece went to its elections with similar notions that it would exit the European union and currency, to date it has done neither. It is easy to rally the disenfranchised to a common catchcry and enemy, especially when that enemy is someone else or a faceless bureaucracy. It is far harder to govern a nation and implement significant economic change.
For the moment we continue see a world that is growing, albeit at a slightly slower pace, a world where interest rates will continue to grind higher and a world where the focus will shift back to company fundamentals and earnings once the next reporting season rolls around again in July and August. In this world we think equities still offer better returns but we are more cautious and we are certainly keeping an eye on the Italian situation. I for one am more than happy to volunteer for a fact-finding mission to Italy.
Andrew Aylward is Chief Investment Officer at Keep Wealth Partners.
Keep Wealth Partners Pty Ltd (AFSL 494858). This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if the strategies and products are right for you.