The eurozone is an economic power, but its survival depends on its ability to implement a common economic policy. Investors have factored in this equation since the 2011-2012 Greek crisis: how cohesive is the eurozone, and alternatively, what is its risk of breaking up? The subsidiary question is: is Italy its Achilles heel?
While the equity markets do not like uncertainty, the Italian political situation has been a source of agitation in recent days. As such, the 10-year yield on Italian government bonds tightened by 98 bp to 3.44%, the Milan stock market fell by almost 6% and Italian banks, which hold a substantial portion of Italy’s public debt (over €600bn), fared particularly badly. Calm returned to the markets on May 30th when the Five Star Movement (M5S) and the League were able to form a government acceptable to the Italian president. It took this unprecedented political situation for the markets to take account of the political factor again, with risk peaking around the issue of eurozone cohesion. Despite this turbulent episode, equities were largely sheltered and there was no major impact on the euro, while at the same time, the Spanish prime minister lost a confidence vote in parliament. The European markets eventually bounced back, the euro picked up to 1.16 against the dollar and bond yields eased.
The markets’ ability to absorb the events, with the ECB looking on approvingly, does not mean that the risk has disappeared. The crux of the matter for Italy is its weak growth coupled with a high level of public debt (132% of GDP). Italy is not Greece in 2012, but the coalition of two extreme parties that hold opposing views is unlikely to bring stability, nor the hope for change to address Italy’s weaknesses, such as its ability to undertake reforms. The implementation of the "common programme" proposed by the new Italian government would cost 6-7% of GDP, and while the primary budget surplus (1.7% of GDP) provides some room for manoeuvre, the opportunities for a stimulus from tax cuts are limited. The lack of flexibility in the Italian economy is weighing on its productivity, its banking system is still recovering and very few family-owned companies are capable of attaining the kind of critical mass that would attract investors.
Italian equities represent around 7% of the Eurostoxx300. A large proportion are banks and companies that operate on international markets. These two segments put in similar performances during the eurozone’s return to a faster pace of growth at the start of the year. At this stage, and even though we can envisage some technical rebounds, we remain cautious with regard to Italian banks, which will feel the impact of each new episode in the political crisis. We are maintaining a constructive view on companies with international exposure, which will benefit from the fall in their valuation and the EUR/USD cross. Mediumsized Italian companies should receive support from the Individual Savings Plan (PIR).
For the eurozone, the political risk premium is likely to be in place for some time to come. Although corporate earnings growth continues to encourage us to buy on weakness on a year-end horizon, we will remain cautious on this market in the coming weeks given the unfavourable trend in recent eurozone statistics along with the political risk.