Investors have responded with a shrug to the collapse of Italy's government. The spread between 10-year Italian bonds and their safer German counterparts has barely budged at around 200 basis points, well below a high of 325 basis points over the past 12 months.
The sanguine response may partly reflect confidence that Italy's disruptive dispute with the EU over budget rules has been resolved, at least for now. Meanwhile plenty of political risk is already priced into the market. Italian 10-year yields remain around 120 basis points higher than bonds of this duration from Spain and Portugal, other riskier Eurozone nations.
But other political risks are on the rise for Europe at a time when growth is fragile.
- Italy's budget dispute with the EU has been postponed, rather than resolved. The deal struck earlier this summer to avoid censuring Italy for breaching budget rules was conditional on fiscal tightening in 2020. The default option for doing so is a 3 percentage point rise in VAT, which would further weaken growth in Italy, the Eurozone's third-largest economy. Alternatives could be found that are less harmful to growth. But though unlikely, it is also possible that the conflict with the European Commission could resurface if Italy fails to control its budget. Meanwhile, the political flux in Italy is a threat to growth and a potential drag on its neighbors.
- The threat of a no-deal Brexit remains. The UK is scheduled to leave the EU on 31 October, and so far there has been scant progress in forging agreement on a withdrawal agreement. UK Prime Minister Boris Johnson has called for an end to the Irish backstop as a precondition for talks with the EU – a request that the EU has rejected. We believe that lawmakers can still prevent a no-deal Brexit at the end of October, and that markets are overstating the risk. However, the risks are material, and a disruptive UK exit would deal a further blow to Eurozone growth.
- Rising global trade tensions pose the biggest threat of all. Recently the US President Donald Trump revived concerns that he could impose punitive tariffs on European imports. "The European Union is worse than China, just smaller. It treats us horribly: barriers, tariffs, taxes," he said in a recent speech. The president also said that tariffs on European autos are "never off the table." Meanwhile, Germany, which is a large exporter of capital goods, has been suffering disproportionately from the slowdown in trade and investment arising from the US trade dispute with China.
So, while the immediate contagion arising from Italy's situation has been modest, political risks for Europe remain elevated. Partly as a result, we are underweight Eurozone stocks versus the US. Meanwhile, Eurozone equities are priced for an overly optimistic macro scenario. We expect corporate earnings to be flat, at best, for 2019.
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