What exactly will we call Italy’s potential exit from the European Union (EU)? Itexit? Brexit was catchy; Itexit isn’t.
All kidding aside, the EU remains a gift that keeps on giving.
No sooner had European growth gotten to a sustainable level and we began talking about the European Central Bank (ECB) looking to exit quantitative easing, than an Italian political mess comes along to rekindle threats to the stability of the EU and the euro.
To be sure, this is not the first time since the 2008 global financial crisis that global markets are being forced to deal with political uncertainty in Europe. We have seen it in Greece, Spain, France for a while, and now Italy. As I’ve said before, a monetary union without a political and fiscal union is inherently unstable. The fact that Europe started growing north of 2% does not change that fact. But, in this regard, it is equally important to note that there is no compulsion to resolve the Italy issue today, either.
Therefore, after all the posturing and hemming and hawing are done, I believe the can will continue to be kicked down the road and no outcome in the near term is likely to solve the inherent instability. As a result, nothing of significance will be attempted. The Brexit negotiations mess (and that is with a country that isn’t part of the common currency), makes it highly unlikely that anyone in the right frame of mind would likely attempt that.
While the causes of this new rendition of a perennial issue are economic in nature, the manifestations have all been political in nature. That, to be sure, is to be expected, as there is no quick and easy economic solution. So, the question is: How does all of this play out?
I do not know for sure. But if the political issues got hot but never boiled over in Greece, Spain, and France, my best guess is that the outcome is likely to be essentially the same in Italy. That is due to the fact that the crisis in Italy is caused by the politically expedient but unlikely alliance between the right and the left, each with very different social and political objectives. But we shall see.
Near-Term Pain for Equities, Credit Likely
However, what is almost certain is the fact that the political crisis is unlikely to fade until Italy’s next election, which won’t be until after the summer. The current crisis comes at a time when the global growth outlook is slowing already. Therefore, an increase in risk premium is likely to be built into global asset prices with painful near-term consequences for global equities and credit.
From a longer-term perspective, while political issues in Europe are important, we also know they haven’t been critical drivers of longer-term trends. Those drivers, ultimately, have been developed market monetary policies.
On that front, the U.S. Federal Reserve (Fed), through the release of the minutes of its most recent policy meeting, has already indicated that slow and gradual policy tightening is the path forward. Further, the Italian and European political situations most likely put the ECB in a similar position and perhaps get it on an elongated path for rate normalization.
After all is said and done, this may prove to be a better outcome than what all of us were expecting, as it will prolong the cycle. If German bund yields remain contained for whatever reason, long U.S. Treasury yields may remain contained, forcing the Fed’s hand in turn, as it is deathly afraid of inverting the yield curve.
Possible Long-Term Benefit?
So, all is not lost on the Italian front. Italians are politicking as they have since the Second World War. This time they may be more serious about it, but my base case is nothing untoward happens because there is no painless outcome. However, the impact of all of this on global monetary policy may be the unexpected medium to longer term benefit.
Bottom line: the Italian political crisis is likely to impact global markets negatively in the near term but, from a longer-term perspective, may make the path of monetary policy normalization shallower and more elongated. That should help the markets in the long run despite the near-term pain.
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