London (Reuters) – Investors are used to the near-inevitability of market volatility in the wake of Italy’s most recent political turmoil, but the hand-wringing tends to end here.
Many claim that the year 2022 marked the return of an era in which politics trumps economics-a time in which the willingness to pay obligations, or even punishments and legal hurdles to those payments, is as important as the ability to pay and the amount of money in the coffers.
The Russian invasion of Ukraine, new Cold War alliances, the removal of a sitting British prime minister, a leadership gap in the United Kingdom, and even the possibility of renewed deadlock following November’s U.S. congressional elections are illustrative of the global political climate.
This time around, the drama in Rome doesn’t seem so unique.
Italy’s latest round of political theater—in the worst-case scenario, elections will be held six to eight months early—is a familiar occurrence, despite the country’s severe economic woes stemming from the Russia-related energy shock, soaring global inflation, and post-pandemic investment priorities.
Italian Prime Minister Mario Draghi, whose resignation was rejected by Italy’s president last week, will determine on Wednesday if he may remain in office until May of next year. Draghi took over as head of a national coalition less than 18 months ago, to near-universal market acclaim.
Major global banks estimate a 30 to 50 percent possibility of Draghi’s resigning and prompting early elections this autumn—just as the yearly government budget needs to be reworked, interest rates in the euro zone are rising, and a winter gas cutoff by Russia looms.
Also, the European Central Bank is expected to announce this week its first increase in interest rates in more than a decade, making it an especially unsettling time to go to the polls.
And ECB specifics on its provisionally dubbed Transmission Protection Mechanism-intended to prevent unsustainable bond rate premia and borrowing spreads between core euro creditors like Germany and more heavily indebted periphery countries like Italy—will be, to say the least, timely.
While there is no doubt that nervous investors can exacerbate a variety of difficulties, from already problematic budgeting to the asset quality of banks, the context is crucial.
Gaps on 10-year Italian debt have nearly doubled this year to more than 200 basis points, but they remain nearly one percentage point below last year’s peaks, much like the 500-plus basis point spreads of a decade ago.
Fabio Faltoni, director of multi-asset investments at Invesco, notes that new Italian debt is refinancing bonds with payments of 5 percent or more, despite the fact that 10-year borrowing rates are above 3 percent. Before Italy begins to refinance at a premium, the yield on the 10-year Treasury note would need to rise beyond 4 percent.
Few believe we have returned to “euro crisis 2.0,” where fears of debt sustainability, probable restructuring, and euro withdrawal loomed.
“MINIMAL” CHANCES
The economic adviser for UniCredit, Erik Nielsen, describes the likelihood of Italy leaving the euro as “minimal” due to the improved functioning of the euro system, even if a remote possibility of debt restructuring within the euro, à la Greece a decade ago, justifies some borrowing premiums and risk pricing.
Nielsen stated, “The drama was largely predicted, even if it occurred three to six months earlier than I had anticipated.” “Party-political posturing prior to the election next year should not have been a surprise.”
While a new ECB soothing mechanism may be considerably more difficult to implement during periods of monetary tightening than the ostensibly ever-expanding liquidity of the previous decade, the fundamental reasons for investor relaxation over Italian debt accumulation are more important.
Stefan Kreuzkamp, chief investment officer at DWS, said he is “cautiously optimistic” about Italy following a decade of political reforms and in light of post-pandemic European Union investment plans that will benefit Italy the most.
This has, for the first time in many years, begun to increase public sector investment, which, coupled with the reforms, should help the country’s longer-term GDP growth prospects.
“Compared to other euro zone economies, Italy is beginning to appear fairly robust on a number of fronts,” Kreuzkamp noted.
Non-performing loans at Italian banks have fallen to their lowest level in the euro era, while the balance sheets of Italian households and businesses appear healthy, according to the DWS CIO, who added that Italy has also been successful in extending the maturities of its debts during the period of low interest rates.
However, he emphasised that debt sustainability essentially depended on keeping the cost of government debt below nominal, not real, economic growth, since nominal was what mattered for tax revenues. The borrowing profile has remained comfortable over the last two years, as inflation has moderated nominal growth rates to more than 7%.
Fred Ducrozet, an economist at Pictet Wealth Management, predicts that Italian bonds will see some pressure as the political situation plays out, but he adds that Draghi had always planned to depart the scene within the next nine months.
However, according to Ducrozet, politics conceals more positive debt dynamics. One of these is the fact that it is anticipated that net sales of new Italian government bonds would be negative for the remainder of the year, as about 60 percent of the sovereign’s funding for 2022 has already been accomplished. This net funding picture is a stark contrast to those of other euro states and a big advantage for Italy for the remainder of the year, given that the ECB’s net asset purchases ceased this month.
Politics and market crises in Italy are often tied together, but it’s important not to get too excited.
The author is the finance and markets editor at Reuters News. His opinions stated here are his alone.
@reutersMikeD, Twitter (NYSE: TWTR); Paul Simao, editor.
