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John Authers has an excellent (as ever) report from Rome in his daily email for Bloomberg this morning.
He discusses the political situation in Italy, and runs through why some investors are worried that Italy could drive a sovereign debt crisis in the eurozone.
Put simply, Italy has lots of debt and it has a populist government which only looks set to get more populist as the more aggressive members of the current coalition win more power.
That sets up a confrontation with the EU, because Italy wants to spend more money than the EU wants it to.
And markets could force the issue by driving up Italian borrowing costs until either the European Central Bank has to intervene to cap yields, or Italy runs out of money.
Sounds like a sticky situation. It sort of is.
But I’m betting it won’t come to anything.
Italy and the EU can reach a compromise, although it’ll cost Germany
I don’t think that Italy will trigger a sovereign bond crisis in the eurozone.
The Italians have learned from the experience of both the Greeks and the British. They are also in a very different position to both of those countries.
The EU does not want to lose Britain and it did not want to lose Greece. But at a push, it can cope with either of them leaving.
By the end of the Greek crisis, all those years ago (it really was – I woke up the other day and realised it’s been nearly seven years since Mario Draghi’s “whatever it takes” speech – I can’t believe it), the EU was ready to cut Greece loose. Then, ultimately, Greece stayed in the euro by choice (not much of a choice, admittedly, but it was a choice).
As for Brexit, it’s clear that the EU will take any opportunity to avoid the hassle of the UK leaving. But whatever happens with us, we don’t represent an existential threat to the EU simply because we don’t use the euro.
(And we’ve already agreed deals that mean the eurozone financial system can still use the City’s derivatives trading facilities – that could have blown things sky-high for everyone, which is one reason that a deal was done sharpish, regardless of red lines or posturing in other areas.)
Italy is different. Italy is critical to the ongoing existence of the EU. If Italy were to leave, it would be very hard to see any scenario in which the euro would not implode. Italy is one of the biggest issuers of government debt in the world, and the biggest in the eurozone.
Do you fancy the financial system’s chances if that sovereign borrower defaults or re-denominates its debt? Nah, I don’t either.
So the EU can only play so much hardball with Italy.
On the other hand, of course, if any of this were to happen, things wouldn’t be great fun for Italy either. No one with any savings in Italy wants to go back to using the lire.
All that Italy really wants is for the euro to be more like the lire, and for the Italian government to be able to spend as much money as it likes without being told off by the EU authorities.
So if you think about it, there’s an easy compromise in ready reaching distance here. Italy isn’t opposed to the EU – it just wants to wrestle it away from having a “hard” money fetish towards being more inclined to “soft” money policies. Low interest rates, permanent quantitative easing – that sort of thing.
And let’s be honest here: most countries in the eurozone would be more than happy with that, France in particular (where the populists might not be in charge, but are certainly more vocal on the streets than anywhere else). The only real sticking point is Germany, because it sees itself as paying for all this.
So it strikes me that the path of least resistance for the EU is to strike a deal with the Italians. You then bet on the Germans feeling sufficiently bound by the rules and a responsibility towards the EU cause to essentially just suck it up. If they don’t – well, you cross that bridge when you come to it.
What does this mean for investors?
What’s my point? We’ve said it before here, but don’t bet on Italy causing a eurozone meltdown. Certainly not this year. And I do think that if there’s an existential crisis at any point, then it’s more likely to boil down to a confrontation with an indignant Germany. Who I suspect will back down, although we’ll see at the time.
What does that mean for investors? Well, right now Italy is the sixth-cheapest market in the world, according to the rankings at StarCapital (a great website which ranks global markets by Cape – the cyclically-adjusted price/earnings ratio – and other key valuation measures).
Now, I’d point out that no market is really dirt cheap right now (except maybe Russia and Turkey), thanks to loose monetary policy and all the rest of it.
Also, the UK is sitting at position number 12 (out of 40), which strikes me as bargain levels for a country that rarely gets that cheap relative to its peers. So Britain is a “buy” as far as I’m concerned, and if you don’t have much money in the UK you might want to prioritise that first.
But am I tempted to add to any positions in Italy? Yes, I have to say I am. In fact, the main thing that puts me off is the concern that the pound might strengthen against the euro, if and when Brexit clarity appears.
Then again, I try to avoid worrying about currencies too much (it’s mostly swings and roundabouts) when buying assets for the long run.
I’ll give it some more thought. But certainly one for your watch list.
By the way, I talk more about why a strategy of buying cheap markets, regardless of how ugly they look, can pay off handsomely for a contrarian investor. Better yet, it’s a strategy you can follow even if you’re relatively lazy – find out more in my book, The Sceptical Investor. You can get 25% off here.