Can the Eurozone Survive Italy's Latest Crisis?

Italy's political problems are less of threat to the Eurozone than markets think, says J.P.Morgan's Global Market Strategist Kerry Craig

J.P. Morgan Asset Management 30 May, 2018 | 2:31PM
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This article is part of Morningstar's "Perspectives" series, written by third-party contributors.

 

M5S Leader Luigi di Maio

World markets are rattled by Italy’s failure to form a stable government and a new round of elections in the summer raises the spectre of the 2012 Eurozone crisis.

Italy, which is on to its 66th government since it became a republic in 1946, now averages a new government every 13 months. Markets fret because the shift towards a populist government in Italy has the potential to be much more damaging given the size of Italy’s economy, debt burden and bond market. Italy is 15% of the Eurozone economy, making it the third largest but with a debt to GDP ratio of 130%. Greece is the only economy to have a larger debt burden of 176% debt-to-GDP, but is less than 2% of the Eurozone economy. Then there is the debt market itself.

The total amount of outstanding Italian government debt is €1.5 trillion, about twice the size of outstanding Spanish government debt. Given its size, the ability for organisations such as the European Central Bank to provide an adequate back stop should yields really get out of hand could be constrained and ECB chief Mario Draghi’s famous statement to "do whatever it takes" will be tested.

However, the region has come a long way since the depths of the European debt crisis. Economic growth is much healthier in the region, unemployment is falling and consumer confidence is near all-time highs. Meanwhile, contagion effects are contained by the fact that the level of Italian government bonds held by European banks outside of Italy has halved since 2008 and new mechanisms have been introduced to facilitate the stable flow of credit and provide liquidity to the financial system.

Completely dismissing the risk that Italy poses would be unwise, but a bit more perspective may show that the country is less of a threat to the Euro project than it once was.

Euro is Well Supported

Italians still like the Euro and the fear is that any new Italian government will be formed on a platform of ditching it. However, an increasing number of Italians actually support the single currency. As with many of the European elections since the crisis, their outcome has been more about instigating a change in the political system, rather than simply about leaving the single currency bloc.

Italian Survey

The region is still in recovery and has capacity to grow. Unlike the US, the Eurozone, was a late starter, suffering two recessions since 2008. There is still a significant amount of economic repair to be done and capacity to be used up before the cycle ends. The unemployment rate in the US is at its lowest in decades, but in the Eurozone it’s yet to fall to pre-crisis levels.

Better growth and lower valuations combine to possibly generate stronger returns. Valuations in many markets are at average or above average levels, leaving investors to wonder if they are starting to pay too much for promised earnings. The slower pick-up in the Eurozone means that valuations are not as challenging and actually trade below long run averages.

The lower starting point on valuations as well as a still improving regional growth outlook means that the longer run returns from Eurozone equities could be better than many other regions. Based on expected returns from our research, Eurozone equities could be one of the best performing asset classes over the next decade.

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J.P. Morgan Asset Management  is the investment arm of JPMorgan Chase & Co. and it is one of the largest active asset managers in the world.