It took the Roman empire some 500 years to decline and fall, and Byzantium lasted almost a millennium beyond that. It is tempting to think that Rome has just packed almost as much history and turbulence into the past week alone. But at the end of a week in which markets appear to have gone full circle, we need to step back and ask exactly what has happened and what has changed.
The prime event of this week came on Sunday when Italy’s president turned down the proposal by the country’s populist parties of the left and right to form a new coalition government. Investors were already terrified by the prospect of the rightwing League and more leftwing Five Star Movement taking power. But this roadblock for the populists made things far worse.
That was because the crisis seemed likely to portend another election, in which Italy’s membership of the EU and the eurozone would be a critical issue. The proposal to appoint a Eurosceptic as finance minister was what the president could not accept. The EU is unpopular in Italy, which is a major economy (unlike Greece) and a member of the eurozone (unlike the UK). Any increase in the chance of an Italian exit required a sharp adjustment in perceptions of risk, which happened on Monday and Tuesday. National holidays in the UK and US on Monday made those adjustments more abrupt.
By week’s end, the Italian imbroglio had been resolved, like many before it. The populist coalition will have its chance. The threat that the Italian populace will be given the chance to vote themselves out of the euro has been deferred.
Meanwhile, on Thursday night, Spain ejected its own prime minister, Mariano Rajoy, to almost no international consternation at all: Spain seems far less likely to revolt against the EU, despite its parlous politics.
Where has this left us? Italian risk, as expressed by the spread of Italian 10-year bond yields over the yields on equivalent German bonds remains very elevated. At 2.3 percentage points it is down from more than 2.9 percentage points earlier in the week — but back in April, when the identity of the government was uncertain, the spread was only 1.1 percentage points.
International stocks fell, and threatened to break below a long-established upward trend — and then recovered. The FTSE MIB, main indicator of Italy’s stock market, has actually outperformed the rest of Europe for the year so far, according to FTSE.
And as investors fled the crisis in the eurozone, they did what they had done in the past, and poured into US Treasury bonds. They also reassured themselves that the Federal Reserve would feel obliged to desist from raising rates as planned, thanks to Europe’s turmoil.
This was a very convenient interpretation. By week’s end, all of these market moves had gone into reverse, aided by very strong employment numbers in the US (which would cause investors to sell Treasury bonds again, all else equal). The US announcement that it was pressing ahead with trade conflict over steel with Canada and the eurozone had little if any discernible effect.
But none of this means that everything is fine. The reason the Italian political crisis caused so much angst was the ill health of Europe’s banks which remain bloated and over-levered. This makes them vulnerable to risks such as an Italian default. And as the banks remain huge, they are effectively too big for their governments to save. It is European banking health that makes any risk to the structure of the eurozone so toxic. Eurozone bank shares are down more than 13 per cent for the year, according to FTSE — barely better than they were at the worst point this week.
While Europe’s banks remain this weak, the eurozone will remain vulnerable to debilitating crises like the one that hit this week.
Perhaps most importantly, long-term real yields in the US — 10-year yields after accounting for inflation expectations — did not go full circle. Having briefly hit a post-crisis high of 0.92 per cent in mid-May, they remained below 0.8 per cent in Friday trading, safely back in a range they have hit many times in the post-crisis era. They did so despite excellent job figures for the US, coupled with an ISM survey that showed inflationary pressures rising — which should clearly have raised expectations for higher rates and higher real yields.
Arguably 10-year real yields, reflecting the real cost of long-term money, are the best single sign of the tightness of financial conditions. On this basis, conditions have eased in the past two weeks, after investors had at last grasped that the fiscal stimulus administered in the US at the end of last year would force the Federal Reserve to carry through with higher interest rates. That made investors uncomfortable and had helped to stall the stock market. The S&P 500 is still below its January peak.
But with real yields falling and not rebounding, the strength of US employment could translate into strength for stocks. The most popular stocks continue to go to new highs, in a sign of uncorrected excess — the NYSE Fang+ index, featuring Amazon, Netflix and Google, has hit a new all-time high.
This suggests that Italy’s crisis has, counter-intuitively, allowed the world to delay a reckoning with some brutal financial logic. If the US economy is at last growing well, then financial conditions must tighten to prevent overheating and stock market valuations will have to retreat from their lofty heights.
This denouement remains ahead. But it is unlikely to take as long as the decline and fall of the Roman empire.
Get alerts on Markets when a new story is published