“No plan for Italy to leave the Euro”
Claudio Borghi, Head of Lower House Budget Committee

Presumably Signor Borghi said this thinking that it would reassure Italian financial markets.  It doesn’t seem to be working as of the time of writing, so maybe the question should be “Will the Euros leave Italy?”

Last week the Italian government released their new three year economic plan, complete with an increase in the budget deficit via increased fiscal spending (i.e. the citizen’s income) and some optimistic estimates for economic growth.  On the face of it, it doesn’t look like a very big fiscal expansion, but when you have a total debt level of around 130% of GDP you don’t need a very big fiscal expansion for questions to be asked.  Those questions are being asked by the European Union much to the chagrin of Italian leaders.

So what does the EU have to do with it?  As part of the strengthening mechanisms put in place after the last Eurozone crises, all Eurozone countries signed up to the monitoring of their fiscal plans, including Italy.  There is no desire for further bailouts in the Eurozone and these procedures were put in place to provide an “early warning system”.  The EU is reacting exactly as their rules would suggest and Italian bonds and other financial assets are taking the strain as non-domestic and domestic investors withdraw their investments and thus their Euros from Italy.

So what happens next?  In terms of the Italian timetable, further detail regarding the budget for 2019 will be released around 10th October. If it is in line with their three year economic plan then the EU will not react favourably. And nor may the ratings agencies which represents the really significant risk – and this is what is driving markets now.  Currently Italy is rated Baa2 by Moody’s with a negative outlook.  A downgrade to Baa3 is likely and a negative outlook may be maintained – so just one move away from a junk rating. The implications of the world’s third largest bond market moving to junk are enormous.  The flight of capital from Italy would be vast.

In time, the knock-on effects will be that policy somewhere will change.  It could be that the Italian politicians change fiscal policy, or there is another change of government.  What is unlikely though is any action from the European Central Bank (ECB).  The ECB cannot start Quantitative Easing again, they cannot cut rates, and their hands are tied unless the banking system comes under stress.  There is a mechanism for bailouts and the mythical Outright Monetary Transactions (OMT) policy, but these options are not easy to execute and would only be applied after sufficiently large amounts of Euros from Italy have moved to other parts of the Eurozone.  Any of these policies are completely unacceptable to the current Italian government in its present state.

Lastly it is worth mentioning that given the growth and popularity of passive and index tracking funds across the investment management industry, these funds will not be able to reduce their allocation to Italian assets unless they are removed from their benchmarks.  These funds are a low fee way of accessing bond markets, but investors must consider whether that is what they really want for their bond market allocation in this more challenging market environment.

Do you want low fees but full exposure to Italian bonds? Consideration of paying up for the optionality of not having that exposure must be worth a thought.

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