News vs. Noise: What Investors Need to Know about "Quitaly"

    

Author: Adam Phillips 

Breene Murphy, Director of Client Experience, recently sat down with Adam Phillips, CFA, CFP®, Director of Portfolio Strategy, to discuss what investors need to know about the political headlines coming out of Italy.  Below are the key takeaways from their discussion.  If you have further questions, please do not hesitate to contact your Financial Advisor.

Breene:  Italy has received a lot of attention from financial media outlets over the last several days.  What happened to make this a front-page story and what impact has this had on markets?

Adam:  Nearly two years after the “Brexit” vote, when the United Kingdom held a referendum to exit the European Union (EU), the focus has now shifted to Italy where sentiment among voters reflects a growing desire for independence.  In fact, in a November survey by Eurobarometer, only 59% of Italians favored remaining on the Euro, compared to 74% for all members of the currency bloc (see Chart).

 

 

Since receiving the majority of votes in the March general election, the antiestablishment League and 5-Star parties of Italy had been working on forming a coalition government to pursue their collective political agenda.

Last week began with news that Italian President Sergio Mattarella had exercised his authority to veto the coalition government’s nomination for economy minister who held well-known euroskeptic views.  This opened the possibility that Italy would have to hold new elections for parliament in the coming months, an event that risked seeing even greater voter support for the populist and anti-Euro parties.  Not surprisingly, global equities fell sharply on the news as investors retreated to safe-haven assets such as U.S. Treasuries.  Meanwhile, the euro fell to its lowest level in nearly a year.

Fortunately, after going back to the drawing board, a new governing coalition was formed and approved by President Mattarella by the end of the week.  While investor angst surrounding another snap election has been avoided, uncertainty remains of how this a government will work with the Italian head of state and other leaders across the European Union going forward.

We love our buzzwords and acronyms in the investment world, and many are now referring to this drama as “Quitaly”.  I suppose “Italexit” wouldn’t quite have the same ring to it, but the prospect of Italy exiting the EU is unnerving no matter what label you assign to it.

 

Breene:  As the situation continues to unfold, how will these events impact investor portfolios?

Adam: For now, “Quitaly” adds to a long list of geopolitical risks that could impact markets over the short-term.  Client portfolios are well diversified, so direct exposure to Italy generally accounts for less than 1% of a balanced portfolio.  That is not to say that portfolios will be immune to short-term volatility caused by developments coming out of Italy.  After all, last Tuesday’s headlines saw indiscriminate selling across all risk assets.  However, last week also showed how quickly news can change, so it is important not to give in to the herd mentality of investors.

As we have often reminded our clients, short-term volatility is no reason to abandon a long-term strategy.  In addition, even if Italy elected to leave the EU, the transition would take time to play out.  Nearly two years removed from the historic Brexit vote, the two parties are still trying to negotiate the terms of their divorce.

 

Breene:  My understanding is that Italy also has significant debt obligations.  Even though nothing is imminent, would the EU be better off without them?

Adam:  Italy’s debt issue is severe. The country has a debt-to-GDP ratio in excess of 130%, which is the second highest in the Eurozone and fourth highest in the world.  Unfortunately, this ratio has been moving in the wrong direction, as this number is up from 120% just five years ago.

Italian government debt represents nearly 25% of all public debt outstanding in the Eurozone, so a case could be made that the EU as a whole would be better off financially without Italy in the picture.  For perspective, when the Greek debt crisis began in 2010, the country’s debt obligations accounted for just 2.6% of all public debt outstanding in the currency bloc.

However, this decision is not so cut and dry.  Italy is a large economy, and accounts for over 15% of Eurozone GDP, compared to around 3% for Greece.  Therefore, the departure of such a significant member would likely put the future of the common currency at risk.

Fortunately, Italy’s debt problem is not all bad.  First, the majority of debt is held by domestic savers, followed by the European Central Bank, which owns an estimated 17% of outstanding debt.  In fact, only around 5% of Italian debt is held by investors outside of Europe.  In addition, the average maturity of Italian debt is roughly seven years, which means that repaying maturing loans is not an immediate concern.

 

Breene:  What sorts of questions might our EP clients want to ask their advisors if they do have more questions?

Adam:  Although our longer-term outlook remains positive, it would not surprise us to see volatility continue over the near-term given the various issues unfolding on the global stage.  These periods of volatility can test an investor’s discipline, and I would encourage any clients that have remaining concerns to contact their Advisor to discuss how the current environment is impacting their overall financial plan.

 

Breene:   Thanks for your time and insight, Adam!

 

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