Tired (or maybe bored) of worrying about rising interest rates, a rising dollar and higher oil prices? Then fear not, because according to Bloomberg macro strategist and former Lehman trader, Mark Cudmore, you can now start worrying about a new, or rather well-forgotten, potential risk flashpoint, namely Italy which, as he writes in his latest Macro View note overnight, is “on the verge of inducing a fresh European crisis.” Full note below.
Italy on Verge of Inducing a Fresh European Crisis
It may be time to move on from rising Treasury yields and trade wars. An Italian-led euro crisis is on the verge of becoming the dominant theme for markets.
It turns out that the euro break-up trade isn’t dead — it’s just been hibernating and is likely to return with a vengeance in the months ahead if the populists get their way.
Their proposed economic policies make no attempt at debt sustainability. Italy already has the largest absolute debt pile in the EU and the second-largest, after Greece, as a percentage of GDP, at 132%.
The coalition’s plan sends the signal that it has no intention of ever paying back its debt. Things could spiral quickly because its fiscal promises will send BTP yields much higher, adding to refinancing costs and making the budgetary situation worse.
That creates a dilemma for the EU. Either fund Italy’s largesse at the expense of every other member country, or kick Italy out of the euro.
The first option isn’t sustainable. This isn’t a relatively containable problem like Greece. Italy’s economy is almost ten times the size of Greece’s and the third-largest in the euro zone. The PIIGS — Portugal, Italy, Ireland, Greece and Spain — were only ever a problem as a group because of concerns that the contagion would infect Italy.
And this isn’t just a sovereign debt problem. Italy’s banks have by far the most non- performing loans in the euro zone, more than a quarter of the total. A section of the plan makes it harder for banks to repossess collateral, further deteriorating the value of those loans.
So while the policy platform doesn’t explicitly state an intention to leave the euro, the new government plan, if instituted as is, makes that the inevitable end-game.
Fortunately, the Italian constitution forbids an excessive budget deficit, so may act as a limiting force. However, the concern is whether they can circumvent those restrictions by selecting favorable economic projections.
The proposal already seems to be stealthily planning for euro departure with a plan to issue short-term debt contracts to pay back arrears. As my colleague Ferdinando Giugliano suggested on Friday, that’s the first step toward a parallel currency.
So Italy’s prospective rulers seem to be fully aware of the end-game and are already planning for it. Investors will soon need to catch up.