The anti-establishment Five Star Movement and League have been sworn in to form a coalition government in Italy, finally bringing an end to nearly three months of political deadlock.
It’s been a messy week for the markets as the political uncertainty in Italy came to a crux, with bond yields reaching levels not seen since the height of the eurozone crisis. The story has been fast-paced, and it’s been difficult to keep up with what has at times seemed fictitious.
President Mattarella accepted the list of cabinet nominees re-submitted by designated Prime Minister of the coalition Giuseppe Conte on Thursday, paving the way for the alliance to be sworn into government on Friday.
Head of Five Star Movement Mario Di Maio has taken the post of vice-premier and Minister for Labour and Economic Development, whilst head of the far-right League has a vice-premier role, along with being the Interior Minister of Immigration.
The much coveted Finance Minister role has gone to Giovanni Tria, professor of political economy at Tor Vergata University in Rome, whilst the former candidate Paolo Savona serves as Minister for European Affairs.
After going head-to-head in the Italy’s March elections, this agreement symbolises an impressive rise to power for the two populist parties. Spearheading policies on tax cuts and spending reform, the new coalition government will also test Italy’s relationship with the EU.
Impact on the financial markets
The political uncertainty plunged financial markets into turmoil this week. If Mattarella was really trying to protect Italian bond-holders when he first rejected Conte’s Finance Minister nomination, then he slipped at the first hurdle.
This week we’ve seen the highest volatility in the yield of two-year BTPs since 2000, and the yield curve flattened quite considerably – although this is relaxing to more of its usual shape. The cost of borrowing in Italy soared to highs not seen since Europe’s sovereign debt crisis, and the spread between German and Italian bond yields widened to its largest since 2013.
Essentially, by trying to protect Italian debt, Mattarella took a big swipe to it. And it wasn’t just bond markets that gyrated this week, as a sell-off in Italian equities spread across Europe and to America as investors feared contagion.
Italy, debt, and the bond market
Italy’s government debt is quite high at 130% of GDP. In Europe only Greece has a higher number. High levels of debt are a confidence game. Provided people believe you can pay (or believe that the ECB will keep buying), bond yields stay low and the government can keep paying.
Lose investor confidence, and investors start demanding a higher yield to own your debt. Higher interest payments compound your problem. In extreme cases, people demand a price that is simply too high – so they walk away.
This doesn’t matter quite so much if you control your own currency, you simply print money and pay off the debt. But if you don’t, then things get a bit more complicated.
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To look at the trajectory of debt to GDP, take a look at a country’s primary balance, the cost of debt and nominal GDP growth.
When you look at these numbers for Italy, there’s both good and bad news. The good news is that Italy has consistently run a primary surplus since 2014. The government spends less than it takes in, before considering interest payments. It’s a good start.
The bad news is that after interest payments, the government is in deficit. Not a huge deficit, only 2.5% of GDP, but unhelpful in the context of a high starting debt to GDP.
This isn’t too bad in the short term. If you extrapolate the recent past forward, debt to GDP remains relatively stable. But that assumes interest rates stay low and the government continues to generate a primary surplus. “Populist” policies probably aren’t likely to give you that outcome.
Italian debt dynamics do look sustainable, just about. But there’s not much room to slip on either the primary surplus or the cost of debt. And you would argue that those two are related – spend too much, and the government is likely to find itself facing higher debt costs. Policies designed to cut taxes and spend more will certainly test this equilibrium.
That’s a difficult call for people tired of a decade of austerity – and the parties they’ve recently elected.
The role of investment advice during uncertainty
Whilst markets have had a busy week, the fallout is unlikely to stretch over the long-term for diversified investment portfolios.
Diversification is key to managing sector-specific risk in your portfolios, but it’s important that your investments suit your investor profile, time horizon and priorities.
The financial markets can be an intimidating place when you’re on your own. It takes a lot of time, knowledge and skill to invest on the financial markets, which can encourage people from making the wrong decisions with their money, or put many off from investing in the first place.
Investing is personal, and it’s crucial your portfolio reflects you – what’s right for your friends, family and famous investors, might be bad news for you. Investment advice ensures your portfolio is built in the right way to help you reach your goals.
Here are five tips for investing during uncertainty:
- Diversification – spread your money across investments, asset classes and geographies to minimise sector-specific risks
- Think for the long term – sometimes the best thing you can do is nothing. Avoid potentially costly knee-jerk reactions by ignoring market noise and focusing on the long-term
- Invest regularly – Regular investing can reduce the amount you pay for an asset over time, especially during periods of uncertainty. This can help maximise your returns over the long-term
- Make the most of your tax relief – When you invest in a pension, you get tax relief relative to your income tax band. This means you can pay just £8,000 for a £10,000 contribution to your pension. Remember to claim any further tax relief through your annual tax return if you’re a higher or additional rate taxpayer.
- Investment advice – Invest in the right way for you to help you reach your financial goals. At Moneyfarm we match you to a portfolio that’s built to reflect your investor profile, the amount you’ve invested versus your current wealth and time horizon, and continue to manage this to ensure you’re in the best position to reach your goals