The formation of an unlikely coalition government by Italy’s Five-Star Movement (M5S) and Northern League threw financial markets into turmoil last month. After it transpired that abandoning the euro was a possibility envisaged by the two parties, the country went on the kind of political roller-coaster ride that should qualify as an Italian speciality. As a result, the Euro, European equities and particularly sovereign bonds from the Eurozone periphery all took a beating.
The negative consequences of a country leaving the EU cannot be understated. The departure of Greece, Italy or any other member would set a fatal precedent. If events were to demonstrate that such a move could indeed be pulled off, investors would need to calculate exit probabilities for every country in the bloc. At that point, one euro wouldn’t have quite the same value throughout the Eurozone any more. Investors would have a strong incentive to shift their euro holdings from vulnerable countries to safer ones. The euro would soon cease to be fungible – that is, to exist. A great deal is therefore at stake.
From a technical standpoint, there is nothing to prevent a sovereign country from reverting to its national currency. In reality, at least two conditions must be met before that can happen. First, there has to be a will to leave. In Italy, all the latest opinion polls show that a majority want to stay in the Eurozone. A democratically elected government may of course adopt policies that run counter to popular will but coming from a populist government, that would look incongruous to say the least.
Secondly, it would have to be a surprise move. Advance notice of plans to ditch the euro would automatically trigger an immediate capital flight that would leave the government penniless before the process even got started. Consequently, the government pursuing “Italexit” would be a most unlikely outcome.
Does that mean that Italy will soon fall back into line? And that financial markets will consequently resume their upward climb, buoyed by the convergence in Eurozone borrowing costs that the reassuring Mario Draghi kicked off in the summer of 2012? That seems quite doubtful and there are two reasons for this. Although Giuseppe Conte’s newly approved administration can’t announce plans to give up the euro, it fully intends to challenge the fiscal austerity mantra. While financial markets are unlikely to applaud deeper budget deficits, that prospect shouldn’t prove too damaging initially as Italy still has firepower to spare. (The country is currently running a smaller budget deficit than France, and also boasts a current account surplus.) Furthermore, Matteo Salvini’s obsession with migrants could conceivably give Brussels a bargaining chip for getting Rome to agree to economic policies that financial markets find acceptable in exchange for assistance on the migration issue.
The second reason for concern goes deeper, and is not confined to Italy. Very little progress has been made to date on structural reforms in either individual member states or at the EU level. This failing has so far been hidden from view by the European Central Bank’s ongoing active policy support and the economic upswing under way. This could become glaringly obvious once the economy starts slowing in the next few months, particularly if the slowdown coincides with a gradual withdrawal of ECB stimulus. As long as reform remains too feeble to lighten the debt loads of the Eurozone’s more fragile, non-core members, investors won’t indulge them to the point of letting them loosen the fiscal purse-strings unless they offer substantially higher yields at the same time.
Meanwhile, the European Union probably still won’t have adopted a budget that is hefty enough to offset the shortcomings of its more vulnerable members. In other words, the weakest countries will get the short straw and the process of convergence across the Eurozone that has been such a boon to equity, sovereign bond and corporate credit markets these past six years will stutter. That outlook alone is enough to justify the sense of urgency that Emmanuel Macron has been trying to infuse into his reform agenda in France.
To conclude, neither monetary nor fiscal policy will have the same flexibility as before to mitigate the next economic slowdown. The next phase in the economic cycle will therefore be critical for investors. It will require them to break the habits they have fallen into since 2012 and take a cold, hard look at how they manage market risks.
Didier Saint Georges is manager director and member of the Investment Committee at Carmignac
