Fears of a fiscal showdown between Italy’s new government and the European Union (EU) have roiled Italian assets this year – and renewed concerns about EU cohesion. How worried are we? We see a limited risk of near-term flare-ups but are skeptical about the Italian government’s commitment to fiscal discipline and Europe’s ability to cope with the next downturn. We see better risk-return tradeoffs in non-EU assets.
Italian assets have taken a hit this year. The selloff was sparked by fears that Italy’s populist government would breach the EU’s key budget deficit limit of 3% of gross domestic product (GDP), as the two major parties in the new governing coalition had vowed to cut taxes and boost welfare spending in their campaign. Italian 10-year government bond yields spiked after the March election, while local stocks fell. See the chart above. Italian assets have recouped some losses recently, only after Rome repeatedly assured it would respect EU rules in its soon-to-be released budget. We see scope for a further recovery in Italian asset prices, but do not see them returning to pre-election levels anytime soon. Why? A number of structural factors are weighing down both Italian and European assets. This helps explain why European stocks have under-performed other global developed markets in 2018.
Our budget base case
All eyes are on Italy’s 2019 budget, which will be viewed as a gauge of the country’s needed commitment to fiscal responsibility. Our base case: The budget–to be announced this week and submitted to the European Commission by mid-October–is likely to be moderate enough to win EU approval. This should create some room for assets from Europe’s periphery to rebound further. Yet structural issues bubble below the surface. A further deterioration in already weak Italian fundamentals–notably a debt-to-GDP burden above 130% and growth potential below 1%–would leave Italy vulnerable to a growth slowdown or external shock, though we see neither as imminent.
As for the region overall, the euro-zone reform agenda is moving in the right direction. Yet we see the progress in motion as likely too small to make a meaningful difference when the next downturn hits. Prospects of a common insurance scheme for bank deposits across the region now appear all but dead, and the framework that would deal with the winding down of a failing European bank is murky. German leadership has been weakened as Chancellor Angela Merkel faces a popular backlash against her party’s immigration policies. It is also crunch time for Brexit negotiations. We expect a deal, but the road to that outlook looks bumpy. Market attention toward the risk of European fragmentation stands only marginally above the long-term average, as our BlackRock geopolitical risk dashboard shows. This means negative surprises could incite a sharp market reaction. At the same time, a truce in trade tensions between the U.S. and the EU has helped relieve some pressure on European companies, especially automakers.
We see a low likelihood of a flash-point between Italy and the EU in coming months, but we remain cautious on longer-term political and economic dynamics. European earnings growth lags other regions, and we prefer U.S. stocks as a result, as well as emerging market equities. Within European equities, our preferences include the industrials and health care sectors.