It has been a stressful couple of weeks for the Eurozone. Government bond spreads – which measure the level of financial risk in the area – have been under pressure from political uncertainty in Italy and changes to monetary policy. In this context, stocks have performed positively, reflecting investor confidence that solutions to most of the problems affecting the European economy will be found. Let’s start by looking at Italy.
The political situation in Italy is complicated. Just a week after Boris Johnson announced his resignation, Italian PM Mario Draghi faced similar upheaval and has since resigned. The end of the Draghi government is reflective of a fragmented political landscape in Italy, with fresh elections expected to be announced for September, meaning both the UK and Italy will see new leaders that month.
This uncertainty has had knock-on impacts on both the Italian economy and the position of the ECB. The FTSE MIB has clearly underperformed versus the equity markets of other countries. The most influential factor is exposure to securities from the banking sector, which have suffered from the widening of the spreads of Italian bonds and the flattening of the interest rate curve.
Equity markets have always been affected by international developments and the FTSE MIB, in particular, is already struggling with the collapse in the price of oil and energy stocks, among other factors. On the bond markets front, the peripheral European countries have suffered and the Italian spread has widened more than other countries (218 points, +6%). There are two main reasons for this:
- Firstly, US inflation data, released earlier this month, has led to monetary policy being tightened in Europe with the ECB hiking rates.
- Secondly, the risk of political fragmentation has increased. This began with Macron, who lost the majority in France, and now the situation in Italy has become complicated.
The ECB hikes rates
In late July, the ECB surprised markets with a 50 bps rate hike, rather than the anticipated 25 bps move, addressing the risk of fragmentation by launching the Transmission Protection Instrument. This complex balancing act highlights the difficult situation the Central Bank finds itself in. It must fight stubbornly high inflation, while managing the risks of fragmentation or even the dissolution of the Euro project – which Mario Draghi’s resignation showed was still a valid threat.
Did the move work? Early signs seem to suggest that markets are reacting in a neutral way to the narrative dictated by Frankfurt, with the various effects balancing each other at least at this early stage, even if the spreads of the peripheral countries remain volatile in the face of doubts about the new tool. Although the details on the ICC are limited for now, this is explicitly aimed at ensuring that European monetary policy is transmitted smoothly throughout the European monetary union and has no limits in the scope of action, even if it is subject to stringent eligibility criteria (particularly on the side of public finance).
This is an instrument that the markets still do not seem to consider strong enough, in a context of high inflation, slowing growth and high geopolitical risk, as shown by the lack of a strong appreciation of the euro against the dollar. Of course, the focus remains on the evolution of political events in the peripheral countries, Italy above all, and on the risk of Russian retaliation in the supply of gas. In this context, the goal of lowering inflation without causing an economic crisis is still perhaps achievable, but certainly more difficult.
How could this affect portfolios?
Moneyfarm’s portfolios have a global geographic exposure with a relatively low concentration on Italian equities. In the short term, however, political uncertainty could contribute to the volatility of European markets, adding to the risk factors already present in the Eurozone.
In the medium to long term, political uncertainty should have a limited impact within a globally diversified strategy. We will continue to monitor the situation and the potential implications for portfolios.