With Italy in chaos, is the Eurozone on the verge of another crisis?

 
Katherine Denham
TOPSHOT-ITALY-POLITICS-ELECTION-VOTE
The current political situation in Italy has reignited memories of the Eurozone debt crisis (Source: Getty)

It's got messy in Italy – so messy that the situation has reignited memories of the Eurozone debt crisis.

Since March, populist parties, the Five Star Movement and the Northern League, have been trying to settle their differences.

But efforts were hampered once again after the Italian President rejected the coalition’s choice of finance minister, which threatened the new government before it even took office.

While the parties accepted a new pro-euro candidate for the role, which seemed to put the government back on track, uncertainty still overshadows the markets.

Read more: Italian anti-establishment leaders resurrect coalition

Italy has had more than its fair share of political instability over the years, having had 23 Prime Ministers since 1980 (by comparison, the UK has had just six).

However, while Italy might be familiar with political turmoil, Christopher Jeffery from Legal & General Investment Management says the latest developments could prompt a new level of chaos.

The proposed overhaul of the tax system and universal basic income is thought to cost around €65bn per year – or five per cent of GDP, which Jeffery says is “clearly incompatible with either European rules or basic fiscal sanity”.

We’ve already seen a huge sell-off in Italian bonds in response to these plans, causing spreads to widen over their German equivalents. The price of Italy’s 10-year government bond plummeted last week, sending the yield surging north of 3.1 per cent – up from 2.4 per cent in just four trading days. And even though Italian bonds have since recovered, volatility is still running high.

But the drama has also hit European stocks – a sign of dampened confidence in the Eurozone.

All of this is worryingly reminiscent of the sovereign debt crisis. Indeed, there are fears that all of this could tip Italy and the rest of the European Union into a crisis – just as Greece did back in 2011.

Star-crossed debt lovers

The Greek crisis a few years back might shed some light on how worried investors should be about the current situation in Italy.

Figures suggest that Italy is harbouring a debt pile close to €2 trillion. By comparison, Greek public debt peaked at around €350bn during the country’s 2011 financial turmoil.

With such a huge amount of debt, Jeffery warns that if Italy were to descend into genuine financial trouble, the European bailout funds would be stretched to breaking point.

But credit aside, the broad picture looks more optimistic for Italy than it did for Greece.

The coalition is no longer seriously contemplating leaving the Eurozone. This is one of the shining lights in a cloud of uncertainty, and also sets Italy apart from what seemed inevitable at the time for Greece.

Leaving the euro would spell disaster for redenominated Italian household savings, for investors who own Italian debt, and for the entire European monetary union, warns Nicholas Wall from Old Mutual Global Investors.

He concedes that Italy’s economy looks more resilient than Greece’s was. For example, Italy has a current account surplus, Italian institutions are stronger than the Greek equivalents, and foreign ownership of Italian government bonds is lower than that of Greek bonds.

But despite this, debt coupled with lacklustre economic growth is a toxic combination. This inevitably puts a substantial amount of stress on the markets, meaning investors should approach with caution.

Read more: What Italy's political situation means for Brexit

To buy, or not to buy?

Markets are now demanding a risk premium in order to own Italian assets. But while investors should be wary of exposure to Italian government bonds in case the country’s debt swells, Jack McIntyre, fund manager at Brandywine Global, says the situation does not warrant the same level of caution as the Eurozone crisis of 2011.

McIntyre points out that Italy’s local economies are performing better, while rates also remain low.

Investors should keep an eye on valuations, which could now start to look interesting for buyers.

Devoid of the political strength to push through eurosceptic policies, you should take comfort from the fact that the worst-case scenario (Italy leaving the Eurozone) now seems off the cards.

With two parties coming together from opposite sides of the political spectrum, we’re likely to see the odd stand-off that achieves nothing apart from triggering market swings.

But with that comes buying opportunities, provided you’re prepared to take the risk.

Related articles