Recent Events in Italy

Recent events in Italy have led to a sharp drop in investor confidence and European valuations. Cambiar examines the parliamentary system and the potential long-term effects.

Recent changes in the balance of parliament led to two parties, the Far Right “Lega” and the Far Left “5 Star” movement, attempting to form a ruling coalition.  However, these groups are very far apart ideologically and represent more populist politics.  It is an odd combination politically to put it mildly.  Consequently, some of the proposals/actions by the potential coalition sound dangerous especially in light of Italy’s high debt loads relative to the rest of Europe.

We would caution a couple of things to concerned investors.  First, it is almost never a good idea to sell emotionally into international macro-driven panics such as this (recall the Brexit panic of just two years ago, this represented a multi-year low for European stock markets) or into the related currency weakness.   Second, we would also caution against an overly-literal reading of financial press “quick takes” on sudden risk events such as this – there tends to be a bit more nuance than can neatly be fit into newspaper columns.  Last on the topic of Italian politics specifically; one should note Italy has had 68 governments since the end of WWII, or an average duration of less than 15 months.  This one probably will last less than the average.  Policy clarity is not a national strong suit.

The basic problem was not actually the alliance of the populists, nor in our opinion was it about the alliance’s well-known desires to add some fiscal stimulus to the policy mix (Lega for tax cuts, 5 Star for spending increases). These are not systemic risks, and plenty of mainstream economists see some room for moderate fiscal stimulus in Italy. The problem came about because the coalition chose to nominate an unacceptable candidate for finance minister, knowing that their government would then fail before it ever started. This particular choice for finance minister is a known skeptic of the Euro and a participant in an alleged “plan B” study for Italy about how to get out of the Euro. The alliance’s aggressive stance suggested confidence among its members of an ability to garner more power in a snap election. The market quickly assumed that this would therefore also be a referendum on Italy’s Euro membership.

Todd Edwards is an Investment Principal at Cambiar Investors.  In addition to his company research responsibilities, Mr. Edwards also oversees…

While Europe’s financial system has added material protections since the “peak Euro crisis” period of the 2011-12 time frame, the continent is far from a full fiscal union, and economic growth in the Eurozone is generally much lower than the U.S., leaving limited fiscal wiggle room for more indebted nations such as Italy.  Sensitivities remain following the Brexit surprise vote of 2016, the diminished clout of more central political parties, and the extreme challenge that more rogue nations (financially speaking) such as Greece have represented to the prevailing order.

Nonetheless, a calmer analysis seems to point in a different direction. First, it is worth reiterating that a majority of Italians favor Euro membership. President Mattarella knows this and called the alliance’s bluff, effectively saying that imposing the unacceptable finance minister equates to national deception, since the two populist parties did not run campaigns based on exit. This means either they need to try again to form a government that reflects what they campaigned on, or in the run-up to the next elections they must make abundantly clear what exactly they stand for.  A campaign based on a desire to exit the Eurozone would likely backfire.

The coalition is in our view a fragile one, putting together two parties from opposite ends of the political spectrum with an exceedingly thin electoral mandate. This fragility may be put to the test fairly soon, as Lega’s popularity looks to be rising while 5 Star’s may be falling. Still, whether the coalition puts forward a more acceptable finance minister or new elections become unavoidable, the medium-term future will not likely center on whether Italy wants to remain in the Eurozone. To the extent that it was exit fear precisely that was priced into the market early this week, we should see moves in the opposite direction as evidence accumulates that the government, whatever form it takes, respects the population’s support of Eurozone membership.

One last point deserves mention, which is the anticipated move by the ECB to eliminate bond buying (QE) in September 2018 followed presumably by a move to higher and positive short-term funding rates some time in 2019.  Europe is by most measures several years behind the U.S. in terms of the economic cycle, with more unusual elements of the cycle dictated by the timing of each region’s deepest financial stress period.  The reader may recall that while the U.S. Federal Reserve sought to begin a series of interest rate increases in late 2015, markets were not in effect completely ready for this, resulting in significant stresses in late 2015 to early 2016 and a long “delay” in terms of policy re-normalization.  Europe, as exemplified by Italy, may be in a loosely similar situation, and the process of monetary lift-off from the 0% level may not exactly occur in a predictable time frame.  Key mechanisms such as ensuring that fiscally compliant nations’ bonds (such as Italy’s) do not trade at onerous discounts to Europe’s best credits (such as Germany) as the ECB exits bond buying remain undetermined.

Ultimately, part of the lesson of the last few days is that even the best sovereign credits cannot reasonably be partitioned from weaker sovereign credits within a common currency, hence the recent Euro currency and equity weakness associated with this episode.  While we do not have a crystal ball, the broad European desire to foster stability and economic linkages through a common currency is high.  To the extent that Europe can (eventually, this may take time) corral these stress points in its financial structure, longer-term upside in both European equities and the currency itself may be considerable.  We have no great visibility on the specific timing of any of this of course, but it is worth pointing out that financial-mechanics problems such as this are ultimately fixable.

 

Disclosures

Certain information contained in this communication constitutes “forward-looking statements”. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts may be based upon third-party sources that are deemed to be reliable, however, Cambiar does not guarantee its accuracy or completeness. Past performance is no indication of future results. All material is provided for informational purposes only and there is no guarantee that the opinions expressed herein will be valid beyond the date of this communication.