Thoughts on EU Political Turmoil

May 29, 2018

Overarching Market Concern

Global markets have recently come under pressure over the reemergence of political and debt concerns in both Italy and Spain. The chief concern for both is the fiscal budget pressure the countries have been under while other EU members assist in providing liquidity. These budget pressures have been viewed as overly burdensome by the voting public, and some anti-EU candidates have been elected to office, ultimately threatening their participation in the euro currency. A move by either Italy or Spain to remove itself from the euro would cause widespread financial dislocation as rules and contracts would need to be rewritten, and there would likely be significant capital flight not just from Italy/Spain but also from other weak EU nations that could follow suit. This is an issue that is likely to reemerge each election cycle, so long as the countries require the assistance of other EU nations to meet debt obligations, and there is a strong anti-EU sentiment in the respective countries.

What is Happening in Italy

The slow and painful deleveraging process that resulted from the 2011 debt crisis has frustrated many Italians who must endure the budget cuts. This has led to populist parties gaining much of the power within the Senate and Chamber of Deputies. On Sunday, Italian President Sergio Mattarella vetoed the formation of a coalition government by populist parties, League and Five Star. Following the veto, Mattarella appointed Carlo Cottarelli as the country’s prime minster, a former IMF official, known for his cuts to Italy’s public spending. This appointment has been taken as a direct rebuke of the populist government from a technocrat President called on to be apolitical. With the new appointment, the current government will be dissolved, and there will be early elections, perhaps as early as July or August.

As a result of the political upheaval, there are renewed questions about whether or not the country will continue down its path of deleveraging. An unwillingness to de-lever may be challenged by the de-facto creditors of Germany and France, which may not tolerate supporting a country unwilling to improve its fiscal position. The reemergence of questions regarding Italy’s debt has caused the country’s 10-year yield to spike. The yield on Italy’s 10-year debt now sits at 3.16%, after being as low as 1.74% earlier this month. The move in rates also causes a more immediate issue for banks and consumers. Italian banks, which have been plagued by non-performing loans and insufficient capital buffers, now must deal with the selloff in Italian debt. The Wall Street Journal reports that nearly 11% of Italian bank assets consists of Italian government debt. This increases the prospects for a banking crisis and/or bailouts.

What is Happening in Spain

Thus far, markets have not been as hard on Spanish financial assets as they have Italy. However, the political turmoil in Spain will come to a head on Friday of this week. The issues facing Spain are more concentrated in the political realm than that of Italy, however, concerns over the populist movement led by the anti-austerity Socialist party remain.

On Friday, Spain’s Prime Minister, Mariano Rajoy, will face a vote of no-confidence brought by the Socialist party. This vote comes as Spain’s National Court has ruled that the Rajoy’s People’s Party illegally profited from a system of corruption that sent 29 people, including party members, to jail. Rajoy himself has avoided that fate by testifying that he had no knowledge of the specific acts of corruption. If Rajoy fails to win the no-confidence vote, the Socialist party would plan to govern for a short period before holding new elections. The Socialists would still need to establish a coalition to form a majority, which may hinder their ability to govern, as each party has its own unique platform. If Rajoy is successful in his no-confidence vote, the country could still end up with a lack of direction. The People’s Party also relies on other political parties to garner sufficient votes to pass legislation, and that support may not be reliable following the vote if perceived political weakness causes other parties, specifically the Ciudadanos, to turn away.

The Spanish government 10-year bond yields have risen in the past month, but not to the extent of Italy. Yields are now sitting at 1.62%, up from 1.25% earlier in May. The rise in yields are putting pressure on Spanish banks. In aggregate, government debt accounts for 9% of assets at Spanish banks.

Response of the European Central Bank (ECB)

As we have mentioned previously, Italy is perhaps the most concerning country with regard to debt. It has the most debt of any country in the EU and third-most in the world, behind the US and Japan. Unlike the US and Japan, Italy has struggled to meet its debt obligations. Economic actors first had to come to a decision on what would happen in Italy, and by extension the euro, in 2011 when market participants abandoned Italian debt. The 10-Year Italian government bond yield rose to 7.2% in 2011. Faced with the prospect of issuing debt at interest rates that would devour their budget, Italy turned to the ECB and fellow euro-members for help. In July of 2012, ECB President Mario Draghi made his version of Hank Paulson’s “Bazooka” comment when he said, “…the ECB is ready to do whatever it takes to preserve the euro, and believe me, it will be enough.” Following those comments, the ECB established their Outright Monetary Transactions (OMT) program, which allowed the central bank to make outright purchases of sovereign debt in the secondary market.

Over the course of its market intervention the ECB has purchased €2.0 trillion, net. Of this, 28.9% has been the debt of Italy or Spain. Under its public purchase plan, the ECB has purchased 23.5% of the total outstanding public-sector debt, which may limit their ability to intervene in the debt markets the way they have previously. The ECB has also purchased private company debt, as well as asset-backed debt. If need be, they may look to purchase equity stakes, particularly in banks, if confidence continues to erode.

What this means for US markets and the Response of GGS

The US equity markets were lower on Tuesday, following the political tension that bubbled over during the weekend. Treasuries rallied as both a flight to safety and lower expectations for FOMC rate hikes put downward pressure on yields. The US 10-year Treasury yield fell to 2.79%, after being as high as 3.11% less than two weeks ago. The narrative domestically remains unchanged, but the case for “synchronized global growth” is weaker today than it was last week. This weakening may be responsible for the short-term weakness in US equities, interest rate sensitive banks in particular, but it is unclear just how much expectations have changed.

At GGS, we have been aware of the debt situation in Europe, and we understand that this deleveraging is likely to take multiple economic cycles to fully play out. As a known macro risk, we continue to explicitly limit clients’ total exposure to the EU, as well as demand an extra margin of safety for any companies with significant operations in Italy and Spain. We are continuing to monitor the situations in Italy, Spain and the EU at large, and we stand ready to take any additional actions if necessary.

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