Senior Economist John Carran takes a look at the effects of this week’s political chaos in Italy.
It looks like the eurozone could face another wobbly period in coming weeks and months as a constitutional crisis erupts in Italy.
On Tuesday night, riskier investments such as shares sold off a fair amount, while safe-haven assets gained due to investor uncertainty about the durability of the eurozone economic grouping and the euro currency.
Trouble had been brewing since the 4 March Italian general election in which a coalition of Eurosceptic parties gained the majority share of the vote.
But the spaghetti hit the fan last weekend when Italy’s president, Sergio Mattarella, nixed the coalition’s nominated finance minister, Paolo Savona - an 82-year-old anti-euro economist.
The subsequent collapse of the coalition and installation by Mr Mattarella of a technocratic government has raised the prospect of fresh elections soon.
Given anger at the perceived anti-democratic actions of the president, investors fear that a new election will raise the vote for anti-euro parties, thus giving them a stronger mandate to govern.
If this fear is realised, it is possible that the new government will prepare a path for Italy to eventually leave the eurozone. As Italy is the grouping’s third largest economy, there would be serious doubts about the survival of the euro as a currency.
This would have major financial implications, including large write-downs of Italian debt, European bank distress, and possible sell-downs of riskier assets worldwide.
However, at this stage I think it is unlikely it will come to that.
FUNDAMENTAL SUPPORT FOR THE EUROZONE
First, it’s possible that in another election more Italian voters will realise that leaving the eurozone is not in their short or long-term best interests. Consequently, support for more moderate parties may rise.
Even if Eurosceptic parties increase their mandate to govern, people’s worst fears may not be realised. The enormous consequences of Italy departing from the common currency will provide a strong incentive for compromises from the country’s government and amongst eurozone members.
The eurozone is as much a political arrangement as an economic one, as a solution to past conflicts in the region. The resolve to keep it together, no matter how unwieldy, shouldn’t be underestimated.
LONG ROAD AHEAD
This saga may take a while to play out. Expect markets to be sensitive to further developments in the near-term, particularly Italian opinion poll results leading up to the election and the comments of key politicians.
Of course, the election itself, whenever that is, will be critical. How the European Central Bank reacts will also be important. No doubt it will want to calm markets as much as it can by promising to keep as much cash in the banking system as needed for it to function normally.
MARKETS CAN BE FICKLE IN THE SHORT-TERM
In response to events in Italy we may see a return of the larger swings in markets that we experienced earlier this year. Conversely, as we’ve also experienced this year, and in the past decade since the global financial crisis, market sentiment can swing around on a dime.
That’s why we try to look through to the medium and longer-term impacts on investments. On this perspective, I believe the outlook at this stage still looks reasonably supportive for riskier investments like shares.
CURRENTLY SOLID MEDIUM-TERM SUPPORT FOR SHARES
Although global activity has moderated a smidgeon, it remains solid.
Company earnings momentum has been strong in all the major markets. Inflation is under control and central banks will only gradually remove extraordinary stimulus.
We’re keeping a close eye on Italy, amongst other risks around the world.
For now though, we’re not seeing a significant change to the medium-term outlook for economies and markets.
This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only.