• The long period of greater European integration dating back to 1950 is being challenged by Brexit and the recent election of a populist Euro-sceptic coalition government in Italy.
• Italy has been at the heart of the so-called European Project since the beginning. However, its poor economic performance since joining the euro on January 1, 1999 has caused severe disillusion among its citizenry.
• Italy’s new government has backed away from its informal calls to leave the euro area, but this is an important risk.
• The key topics for Italy’s new government, and indeed for most European nations, are the completion of the European Banking Union, reform of fiscal policy and a solution to the refugee issue.
• Major differences of opinion exist among nations. The latest E.U. summit on June 28-29 made some headway on the migration issue, but more work needs to be done.
• The other two areas, Banking Union and fiscal policy, are of greater concern for economic performance and are more important for investors.
• Italy wants to implement an aggressively expansionary fiscal policy that will cause its budget deficit to surge and push its big debt load even higher. France and some other nations want to create a euro area fiscal authority that can use fiscal policy to help troubled nations deal with major shocks that before January 1, 1999 required a realignment of exchange rates. Germans are strongly opposed to a centralized budget, believing they would have to subsidize the lack of discipline in Italy’s government budget. It is also why Germany opposed greater debt relief for Greece, instead implementing a package that extends the term to maturity of Greek government debt and delays any interest payments. In return, all Greece must do is run primary budget surpluses (the primary budget surplus is the difference between government revenues and program spending; interest payments on outstanding debt are omitted) until 2060. In fact, there was, and maybe still is a desire in Germany to kick Greece out of the euro.
• It is not just the Germans who feel this way. Several other northern economies agree.
• This split is also holding up completion of the Banking Union, which is designed to help the euro area deal with future banking problems. However, Germany and the northern countries, which seem to be evolving into a new Hanseatic League, don’t want to be stuck with the tab for Italy’s troubled banks.
• Greece got steamrolled in its bailout negotiations because it is a small economy and it did not have a plan B, which would have been to threaten to leave the euro, re-establish its own currency, devalue that currency and default on its debt.
• Italy is a much bigger economy and its troubled banks are a potential threat to European financial stability. It’s bond market is also the world’s 4th largest. This will put pressure on other euro area countries to be more flexible in negotiating with Italy. Italy is also likely to be very aggressive as it was at the recent summit. Given past willingness of the coalition partners to consider leaving the euro, it is also likely to have a Plan B. It is also probable that Italy will want some debt relief to help it deal with its mountain of government debt.
• A big clash is likely to emerge between the Italians and the northern Europeans and it is not clear how it will be resolved, or whether there is any possible solution.
• It is very important for the euro area countries to make progress with their Banking Union plans, fiscal policy and migration for its long-term economic and financial health, and hence for its political stability. It seems to us that this progress is much more achievable without Italy, and possibly Greece as well.
• We feel that there is a material risk that Italy leaves the euro area, and possibly the European Union as well. However, it is the possibility that Italy leaves the euro that has the major implications for investors.
• An Italian departure from the euro and the introduction of a new Italian currency would send a major shock through global bond markets and through the global banking system. If this were to occur amidst the U.S. Federal Reserve’s rate-hiking cycle and escalating global trade tensions, a global recession and financial crisis would become much more likely, as would large losses in equities and corporate bonds.
• This is not something that will happen in the next month or two. But it is something to watch and assess over the next six-to-twelve months, as the new Italian government starts implementing its policy agenda and the euro area nations work on the Banking Union, fiscal policy and the plight of the refugees.
Thank you for reading,
John Johnston and the Davis Rea Team