By: Dividend Sensei
After a freakishly calm 2017 in which stock volatility fell to a 50 year low and the market’s biggest pull back from all time highs was 3%, 2018 has seen volatility return with a vengeance.
First we had an interest rate spike induced correction, (which has not yet ended). Next came fears of a full blown trade war with China, and then concerns that the Federal Reserve would hike rates high enough to trigger a recession. As if all of that weren’t bad enough now we have political turmoil in Italy that could potentially plunge the EU into chaos and have negative ramifications for US corporate earnings and America’s stock markets.
The Dow Jones Industrial Average opened up down 150 points, and as I write this, has been fallen to -450 points so far today. Meanwhile 10 year Treasury bond yields have plunged 11 basis points (a massive amount in one day) as a flight to safety has inspired a major bond rally. What does all this really mean? Let’s take a look at why the market is freaking out over Italian political drama and more importantly what you should do about it.
Italian Political Chaos Stokes Fears Of “Italexit”
Back in March Italy held an election and two populist and anti-EU parties (5 Star and The League) won a substantial number of seats in its parliament. Those parties have tried to team up to form a coalition government, but Italy’s president Sergio Mattarella, blocked their formation of a government (and appointment of a Euro-skeptic Giuseppe Conte as Prime Minister) on Sunday May 27th. He also blocked the appointment of Paolo Savona, a euro skeptic, to become economy minister ( in charge of handling Italy’s 2 trillion Euro national debt).
The reason for this was because President Mattarella is worried that this anti-EU government might end up trying to leave the EU, as Britain voted to do in July of 2016, something the media has dubbed “Italexit”. The League and 5 Star are outraged and demanding new elections, likely in hopes of winning more seats and gaining leverage to form their government. Instead Italy’s President has asked Carlo Cottarelli, a former International Monetary Fund official, to form a new government. This government is likely to be a caretaker government that will only remain in place until new elections are held, potentially in September.
The reason that Wall Street is so scared? Because the head of The League, Matteo Salvini is trying to turn any new election into a potential referendum on Italy leaving the Euro. “It won’t be an election…It will be a referendum between Italy and those on the outside who want us to be a servile, enslaved nation on our knees.” In other words if the election results in the supporters of The League and 5 Star (anti-EU coalition) winning enough power the EU might end up losing yet another major economy and potentially threatening the entire currency and economic union.
Why might Italy want to leave the EU? Because right Italy has been struggling with very slow economic growth after exiting its last recession in 2013. In fact over the past five years its GDP grew an average of .33% per year and in 2017 it hit 1.5%, the fastest growth in a decade. Italy has been running budget deficits of about 2.5% of GDP for the last few years, and its government debt/GDP ratio is very high at 132%. Many Euro-skeptics in Italy blame the country’s economic troubles on the heavy hand of the German dominated European Central Bank.
Some believe that if Italy leaves the EU, and thus goes back to controlling its own currency, then it can devalue its new currency, say by printing lots of new Lira to pay off its debts, as well as increase government spending to stimulate the economy. The devalued currency would also make it cheaper for Italian exporters to increase sales since Italian goods and services (helps tourism too) would be cheaper for foreigners. That’s the theory of the Euro-Skeptics anyway. In reality of course Italy leaving the EU would likely turn out very poorly for the country. But why should US investors care? Because an Italexit could also be bad for US corporate earnings and by extension, the stock market.