Global stock markets rebounded yesterday after political crises in Italy and Spain sent stocks into a tailspin. Unfortunately, for investors things could get worse from here.
This week the country's two largest parties, the left-wing 5-Star Movement and the right-wing League, tried to appoint an anti-European Union politician as finance minister, but it was vetoed by the country's president, who then appointed a new euro-friendly prime minister.
Those moves caused the parties to abandon coalition talks — the country's parties have been trying to form a government since the March 4 election — and call for a snap election, which could take place as early as July.
Last week in Spain the country's ruling party was found to have been involved in an illegal kickbacks scheme, while a former treasurer and close friend of the president was convicted of fraud and money laundering and sentenced to 33 years in prison. The country's prime minister faces a no-confidence vote on Friday.
While both countries' issues contributed to the recent market turmoil — the S&P 500 is down 1.27 percent and the MSCI Europe has fallen by nearly 5 percent since May 22 — Italy's issues are far more damaging to the EU's future. Both 5-Star and League want to leave the euro zone, even though they're on opposite ends of the political divide. If they do form a coalition, or if one party wins outright, then the EU could be done for.
"There's a fear of a potential European Union breakup," said Abe Sheikh, co-chief investment officer with Toronto's Cougar Global Investments. "It's not a huge worry, but when you have a party that at their core runs on platforms that advocate for something like leaving the EU, the probability goes up."
An improving economy
While Italy's political breakdown has been brewing for a while, investors were still caught off guard. After elections in Germany and France last year, both of which came and went with little market reaction, there hasn't been much news out of the euro zone since.
If anything, things have been chugging along nicely. The country's GDP has been growing at 1.5 percent during the last two years, an improvement over the 0.6 percent it grew in 2016, according to the European Commission, and the European Central Bank has been talking about raising its interest rate from zero percent.
Italy is the third-largest economy in the euro zone, and its own financial situation is still troublesome, with its debt-to-GDP ratio a worrying 130 percent, but that number has held steady since 2013, according to Trading Economics.
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"Things have been improving since the European debt crisis in 2011," said Sheikh. "GDP levels in Italy were positive, and even Spain's GDP was around 3 percent. Things were getting better."
A possible financial crisis
Now, though, it's unclear what might happen next. The yield on Italy's 10-year government bond spiked from 2.6 percent on May 28 to 3.1 percent the next day, a sign of investor concern. Bond yields have fallen back slightly, to 2.9 percent, but they're still at the highest levels they've been since 2015. The euro is also down about 1.2 percent since May 22, and 3 percent since January.
If Italy does leave the euro zone, said Amanda Agati, co-chief investment strategist at PNC Financial Services Group — and there's a 5 percent to 10 percent probability of that occurring — then that would result in disaster for global stocks. The euro would crater, too.
Equities didn't react as strongly as some expected they would after Brexit, but this may be different: It would be hard to see how the EU stays together and the euro survives an "Italexit."
"The EU is meant to be a union," said Sheikh. "If anything weakens the union, that can't be positive."
There's also a concern that a political crisis in Italy could trigger another financial crisis. The country is the third-largest debt market in the world, with about about $2.5 trillion of debt outstanding. Its bonds are owned by private investors, governments and central banks, including French and German banks, and the ECB, which holds about 20 percent of the country's outstanding debt.
If bond yields spike too high and the country can't make its payments, these bonds could default, causing investors around the world to lose massive sums of money. There's also a possibility of a bond sell-off — investors may try and dump their Italian fixed income if they're worried about a default.
"What happens to Italian bonds has an effect on the whole financial system," said Sheikh. "It's such a large market, and anything (negative) would impact investor confidence."
See what comes next
At this point, a bond default and EU exit are worst-case scenarios. If former prime minister Silvio Berlusconi's Forza Italia wins more seats and can create a center-right coalition, then markets should stay stable, said PNC's Agati. If 5-Star and League team up to form a government, then volatility will pick up again.
For now, Agati will be watching two things: to see if the ECB waits longer to raise rates and if the Fed decides to delay what many expect will be a July rate hike.
"If there's a shock to the system, then they could have the leeway to slow or delay the next hike," she said. "But this seems to me more of an isolated incident, and the Fed will be more focused on where the U.S. is going."
Investors should wait to see how all of this plays out, added Sheikh.
"Don't be in a rush to buy a political crisis," he said. "Don't be in a rush to get into higher bond yields. We're coming from a backdrop where things are going well, so there aren't any big bargains out there right now."
Saying that, if an investor believes in Europe's long-term potential and Sheikh does think the region will continue improving from here, then people could buy an ETF that focuses on Europe's core countries, like Germany and France. Both places have seen their markets dip by about 3.5 percent over the last week.
In any case, Europe's woes aren't going away anytime soon. Investors should expect more ups and downs ahead.
"It's going to be a bumpy summer," said Agati.