Föhrenbergkreis Finanzwirtschaft

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Forget Trump v. Congress. The Real Political Danger’s Still in Europe

Posted by hkarner - 29. März 2017

Date: 28-03-2017
Source: The Wall Street Journal

Italy is the biggest political threat on the horizon for investors

Beppe Grillo leads the 5 Star Movement, which wants Italians to have a national vote on whether to leave the eurozone.

Politics has been a big driver of markets, but investors may be worrying about the wrong politics. Squabbling over health care hurts the chance of a big U.S. tax cut, and the neurotic can find plenty to fear in the French presidential election. Much less attention has been paid to the biggest political threat on the horizon for investors: Italy.

Italian elections are events investors have learned to disregard after 44 governments in 50 years. The next election might be different, thanks to the potential for a nasty three-way feedback loop between populist politics, the European Central Bank and the bond market.

To see how it could go wrong, think about things from the point of view of holders of Italian government bonds. Their ever-present worry is a repeat of 2011, when a standoff between a populist Italian prime minister and the rest of Europe pushed 10-year yields above 7% (they are now at just 2.37%, even after more than doubling since last summer).

Reassurance comes from the ECB, which is buying €60 billion ($65 billion) of eurozone bonds every month. It has also pledged to buy an unlimited amount in a crisis, via an untested backstop that requires the country in trouble to sign up to International Monetary Fund oversight.

Unfortunately, both are in doubt. The ECB is widely expected to “taper” its bond-buying early next year—just as the Italian election is due. The election, which must be held by May, makes the crisis backstop worthless, as inviting in the IMF would surely scuttle the governing Democratic Party’s chances and boost Beppe Grillo’s 5 Star Movement, which wants a vote on leaving the euro.

“It’s an environment in which the rug of QE is being pulled out from under the Italian economy,” said Andrew Bosomworth, head of portfolio management in Germany for Pacific Investment Management Co.

An ECB taper could be the trigger for rising bond yields, which help populists in the polls, scaring investors and pushing yields higher still.

The reward for holding Italian 10-year bonds amounts to 2 percentage points extra on top of safe German yields. It is impossible to put a probability on the risk of a self-fulfilling spiral of decline, but given how bad it could get, that seems too little reward.

There are four main sources of hope for Italian bonds: Economic, financial, political and monetary. Italy’s economic output per person has shrunk since the euro was created in 1999, a worse performance even than Greece, according to IMF data. However, it has looked a bit perkier recently, and labor reforms have made some progress. Stronger growth makes it easier to service the government debt pile.

The pile is easier to handle, too. For bonds that have been bought by the central bank, Italy is basically paying interest to itself.

Italian politics might work out. 5 Star is leading in the polls but is unlikely to win by enough to form a government if they stick to their refusal to work with other parties. If they do take power, it will still be hard to leave the euro, as last year’s failed attempt to make a much more minor change to the constitution showed.

Finally there is the politics of the central bank. Call it “ItExit” or just say “ciao,” either way the euro is toast if Italy leaves, and the ECB would vanish too. Central bankers in Frankfurt have shown they will do anything to avoid that outcome.

Unfortunately, these reassuring arguments don’t work well in the face of a panic. Debt is sustainable only until bond yields rise so much that it is unsustainable. Like a bank run, panic can become self-fulfilling, because higher yields become a reason to sell, not a reason to buy. After the Brexit vote and Donald Trump’s surprise election win, investors have become cautious about political prospects, too, making them more likely to overestimate 5 Star’s chances. Relying on the ECB to step in eventually, as it did in 2012, isn’t much of a case for buying bonds now, as we can be sure that the central bank will only break its rules in a deep crisis.

Laurence Boone, chief economist at Axa Group, thinks the fragility of the eurozone means there will be a “very slow tapering” by the ECB to avoid a surge in yields triggering problems.

Another option would be a taper with added flexibility about which bonds are bought, abandoning the current fixed allocations between countries, so Italian purchases continue and German buying winds down.

Another crisis is still not the most likely outcome. A shaky Italian coalition and a little economic improvement could push Italy’s date with destiny back another few years.

But it doesn’t take that many bondholders deciding the risks are too great for the problems to spiral. For now investors are focusing elsewhere. When attention turns back to Italy, watch out.


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