Global Perspectives

A weekly analysis of timely economic strategy issues from Wells Fargo Investment Institute.

October 16, 2018

Peter Donisanu, Investment Strategy Analyst

What’s Going on in Italy?

Key Takeaways

  • Global financial markets have been rocked by concerns about financial stability in Italy (among other things). Italy’s budget challenges have increased speculation about eurozone contagion risks.
  • We believe that Italy-related volatility is tied to market participants extrapolating a worst-case scenario into the future. In our view, it is not necessarily reflective of a financial crisis in the present.

What It May Mean for Investors

  • While the risks are growing, we believe that Italy will continue to service its debts and that the likelihood of its problems spreading to the rest of the eurozone are limited in the near term. As such, we consider this view to be supportive of market sentiment in international risk assets.

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Market participants have grown increasingly worried about Italy in recent weeks. One factor contributing to the broad market sell-off came last month as the Italian government presented a preliminary budget to European Union (EU) leaders that called for tax cuts and more spending in an environment of ballooning government debt and structural weakness in Italy’s financial sector. This situation added another brick to a wall of worry that market participants have been climbing in recent months. Yet, we do not believe that this latest development will lead to a eurozone-wide financial crisis in the near term.

Chart 1. Government debt as a percent of GDP—Italy has a debt problemGovernment debt as a percent of GDP—Italy has a debt problemSources: Wells Fargo Investment Institute, Eurostat; October 11, 2018. GDP = gross domestic product.

Italy’s debt problem

Italy has a debt problem, and its EU partners would like it to address that problem sooner, rather than later. The size of Italy’s government debt relative to its economy has grown from 100% of gross domestic product (GDP) in 2008 to 130% of GDP in 2018. Ongoing Italian-government assistance to a banking sector still ailing from the global financial crisis adds to these challenges. The EU’s budget position is focused on getting Italy to address its spending habits, so it can begin to reduce its debt load or (at the very least) slow its accumulation. This is a position also held by private sector credit-rating agencies.

Just as the creditworthiness of a household declines when it spends above its means, some credit-rating agencies have threatened to downgrade Italian debt to junk status if it implements its proposed budget. When Italy’s issues are taken together, markets have a lot to worry about, and the recent market volatility suggests that participants are extrapolating a worst-case scenario. This scenario could include a credit downgrade that likely would prevent further Italian debt accumulation—or forced institutional selling of positions in lower-quality Italian debt.

Lower demand for Italian bonds would push yields higher, increasing borrowing costs for the country when it is already struggling to balance its books. It also could limit Italy’s ability to respond to future banking crises. There is speculation that Italy’s debt challenge may lead some Italians to consider leaving the eurozone. However, such a decision would be so costly in terms of inflation and lost credit access that it seems to be a remote possibility.

Chart 2. Yield spreads versus 2-year German bunds suggest that eurozone bond-market concerns have been contained to ItalyYield spreads versus 2-year German bunds suggest that eurozone bond-market concerns have been contained to ItalySources: Wells Fargo Investment Institute, Bloomberg; October 11, 2018. Past performance is no guarantee of future results. 100 basis points equals 1 percent.

Investment implications

While the risks are growing, we believe that Italy will continue to service its debts and that the likelihood of its problems spreading to the rest of eurozone are limited in the near term. From a contagion perspective, yield spreads versus German bunds appear contained compared to 2011, suggesting that bond markets are not worried about systemic risks spreading to other countries yet (Chart 2). We would grow increasingly worried about eurozone contagion risk if these yields were to widen (rise) as they had seven years ago.

We also believe that systemic risks are likely to be limited, given continued accommodative monetary policy in the eurozone—and the fact that the European Central Bank (ECB) has the tools necessary to address contagion risk. For now, market volatility in Italy appears to be driven in part by politics and by the standoff between the Italian government and the EU. We believe that appetite for risk assets will return to international markets once we get past the Italian budget showdown. For now, disagreements about these budget discussions likely will introduce uncertainty, contributing to bouts of volatility in financial markets.

Economic Calendar Economic CalendarSource: Bloomberg, as of October 12, 2018

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates.

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