Is an ‘Italexit’ on the cards?

Although the unlikely alliance between Italy’s League and the Five Star Movement parties has shown some signs of stress in recent weeks, the gap between the European Union (EU) and the Italian coalition on the latter’s proposed budgetary plans (and the consequent fiscal impact) remains wide. In our view, the Italian government will continue to feel emboldened by the EU’s unwillingness to rock the boat too much for fear of the impact any renewed ‘Italexit’ threats may have on the contentious Brexit negotiations. It is also likely that it will need to make concessions to Italy. These are likely to be characterised as ‘temporary’ in nature – but the EU will want to keep these as discreet as possible.

Despite the EU’s continuing disapproval, the Italian coalition government is pushing for an even more generous pension package for its citizens – already a significant pull on its public finances – while it is also proposing a significant increase to its social spending. Given the coalition’s existing proposals for tax at the low rates of 15-20%, it is hard to see such a move as being sustainable for too long.

No softening so far…

Investors had hoped for some softening of the Italian government’s tough budgetary stance, and that the government’s posturing was simply a ‘Trumpian’ exercise in going for more than you expect to get. So far, however, the government has not budged an inch. With the uncertainty creating volatility in the Italian bond markets, should yields rise above 4% there is likely to be extreme pressure on Italian government bonds. In all probability, this means that the European Central Bank’s (ECB) hands are tied, and that it will be unable to taper the purchasing of sovereign debt (which it has been performing as part of its quantitative-easing programme) to the extent planned.

All of this uncertainty is having a negative impact on Italian business sentiment, and, from our perspective, makes Italy more of a concern than an opportunity at present. For this reason, we are currently highly cautious about Italian assets, and certainly direct exposure. We are watching for a potentially attractive valuation entry point, but as Italy does not have control over its own currency, we don’t think there are a huge number of assets that will look compelling on a risk-adjusted basis if Italy’s economy implodes.

All eyes on Brexit

The Italians will be watching the final outcome of the UK’s and the EU’s Brexit negotiations very closely. The latter will be keen to nail down the draft agreement made recently between Theresa May’s government and the EU, as any successful amendments in favour of the UK might embolden the Italians in their own fraught negotiations with Brussels. For now though, the Italian government is sticking to its guns, although some of that looks like political posturing and at some point it may need to change its stance. However, the EU is likely to be forced to accommodate Italy in some way. An ‘Italexit’ from the EU, or merely the euro, would leave the world’s third-largest sovereign debt market (issued in euros but likely to be serviced unsustainably via a new, weak local currency) in grave danger of default, with potentially cataclysmic systemic consequences well beyond Italy. Furthermore, the idea of losing one of the EU’s founding members would be unthinkable to the EU from a symbolic point of view. Any solution that the EU and Italy come up with will have to be structured in such a way as to ensure that neither side loses face, but for the time being the standoff continues.

Authors

Paul Markham

Head of Global Opportunities