As the European Union rejected Italy’s budget proposal and tensions between Brussels and Rome escalate, investors’ faith in European assets is plummeting, market participants said.
“Italy is the No. 1 risk factor in the fourth quarter” for developed markets, Alessio de Longis, a New York-based portfolio manager at OppenheimerFunds, told MarketWatch, and it hurt the market’s faith in European assets, including the euro EURUSD, +0.1308%
“This is exactly the moment where we get the confrontation and headline risk everyone worried about,” he said.
Italy’s 2019 budget proposal, including the proposed budget deficit equal to 2.4% of gross domestic product, triple the previous government’s plans, has been on investors’ minds since the Italian election in May, as both parties of the ruling coalition campaigned stridently on loose fiscal policies.
The deficit remains under the 3%-of-GDP limit prescribed by the EU’s Stability and Growth Pact, but the worry is that the deficit would balloon further in the coming years.
On Tuesday, the European Commission told Italy to resubmit its proposal within the next three weeks. Earlier Tuesday, however, Italian Prime Minister Giuseppe Conte said Rome doesn’t have a “Plan B,” according to a Bloomberg report.
While the current budget proposal was mostly addressing campaign promises rather than what Italy needs, the real crux was the timing, de Longis said.
“Our macro framework continues to suggest the global business cycle is slowing, led by deceleration in Europe and emerging markets,” de Longis and Ben Rockmuller, senior portfolio manager, wrote in a note earlier this month. “Within developed markets, we further reduced our exposure to European equities in favor of U.S. equities, given the realization of one of the main risks we flagged back in September: Italy.”
The Stoxx Europe 600 Index SXXP, -1.58% dropped 1.6% on Tuesday for its fifth straight loss, bringing its loss so far for October to 7.6% so far in October. On the year, the benchmark is down 9%.
Oppenheimer is also underweight the euro and overweight the Japanese yen USDJPY, -0.48% , which is a haven asset in times of political or economic turmoil. The euro EURJPY, -0.35% has dropped 2.4% against the yen in the month-to-date, with one euro last buying ¥128.74 and touching a 1.5-month-low earlier in the session, according to FactSet.
In another sign of worry, the gap, or spread, between Italian TMBMKIT-10Y, +2.88% and German 10-year government bond yields TMBMKDE-10Y, -9.02% has widened, reaching levels not seen since the European debt crisis, as the chart below shows.
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“Italy is not Greece, as we often hear. Nonetheless, Italy is not in a position to run large budget deficits because, at the end of the day, it doesn’t print its own currency,” de Longes and Rockmuller wrote in their note. “With a stock of public debt hovering around 130% of GDP — higher than during the 2011-2012 European debt crisis — debt servicing costs at 4% of GDP, and nominal GDP growth at 3%, Italy’s math does not add up.”
And while the word contagion hasn’t been used in connection with Italy yet, widening spreads can have a ripple effect on banks’ balance sheets, while equity markets are soggy and business and consumer confidence could get hit.
Meanwhile, the European Central Bank is winding down its quantitative easing program, potentially leaving a gap in demand for Italian government paper that could push yields even higher, market participants fear. ECB President Mario Draghi will likely be asked about the risk permeating from Rome at Thursday’s policy update, but the central banker will likely “refrain from commenting and reiterate that the governing council is regarding the eurozone economy as one,” de Longis said.
If Italy’s second stab at a budget still doesn’t please the Commission, the EU could start an “excessive deficit procedure,” a step it has rarely taken. But this would also deepen the political rift at a time where the EU might want to stand united. After all, Brussels is still negotiating Brexit, which has shown that infighting — that is, in the U.K.’s conservative party — isn’t helpful.
The EU is also running up to parliamentary elections in May, and Italy’s ruling coalition has predicted that a populist wave will take over Brussels. All in all, it raises the question how much noise the Commission really wants to make for now, de Longis said.
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