Thanks to Italy, Brexit is no longer the biggest thorn in the EU’s side. Now Brussels — and global markets — must contend with a populist, Eurosceptic, ragtag government widely feared to blow Italy’s deficit sky-high.
As the coalition government of the anti-establishment Five Star Movement and far-right League emerged, Italian bond yields jumped. Stocks tumbled as investors dreaded the inevitable budget showdown. Rising yields drove fears of Italy’s €2.04tn debt load imploding, upending the global economy and bull market. This feared bomb is a dud. Italian debt isn’t a problem. It’s a buying opportunity.
Yes, Italian bonds have gyrated lately. Italy’s 10-year bond yield touched 3 per cent in late May, the highest since 2014. The spread against German Bunds hit its widest point since 2013. Both spur debt fears. But markets know reality.
Italian stocks, though rocky lately, are flattish for the year-to-date.If Italy had a true debt crisis alongside a new populist government widely feared to add debt endlessly, its stock market should be among the world’s worst. Forward-looking stocks see everything bonds see. Yet since the start of this year, Italian equities have been beating super-strong Germany and Switzerland.
Those widely watched Bund spreads don’t matter. Benchmarking Italian debt to another euro-based asset overlooks currency flows. If investors fear the euro blowing apart, they can’t buy Bunds as a haven. They trust Swiss francs, but Swiss markets are tiny. They trust sterling, but UK markets aren’t big enough to shelter all scared capital.
Fearful investors will buy some of each, but the majority will flow to the US dollar — the world’s true haven in a crisis. And in every crisis, the dollar rises. America’s Treasury bond market is $18.4tn, eclipsing the UK’s £2tn and Germany’s €1.09tn. Only American debt is big enough to absorb that extra global crisis demand, so panicky money flows there.
Therefore, Italy’s proper “risk-free” benchmark rates are US Treasury yields. Ten-year Italian yields are in effect identical with 10-year US Treasury rates. If Italy’s debt was truly risky, investors would charge a huge premium to lend there. In 2011-12, the spread topped 500 basis points. Markets have already priced widespread fears of parallel currencies, tax cuts and soaring public spending — with no risk premium. Trust the market. It’s screaming that this is a false fear.
Perhaps even more shocking — relative to history, Italy’s debt is stellar. Yes, its much-discussed debt-to-GDP ratio is 133 per cent, which trails only Greece in the eurozone. But this compares debt accumulated over decades against annual economic activity. That means little about solvency.
The more critical question is can Italy afford its debt interest payments? The answer is yes. One reason is the increase in Italy’s debt maturity, as the Financial Times’ Kate Allen and Miles Johnson showed. Italy’s average debt maturity has risen, currently hovering just below seven years. In 1994, it was about three years. Longer average maturity makes it harder for bouncy interest rates to impact debt service costs.
Which are quite low. As set out in that article, annual interest expenditure is less than 4 per cent of Italy’s GDP — miles below the 11.4 per cent of GDP paid in 1993, the height of the ERM crisis.
Even more critically, Italy can easily meet those obligations. Current interest payments are 14 per cent of annual tax revenue, a multi-generational low. In the 1990s, carrying costs routinely exceeded 40 per cent of revenue. Yet Italy grew and stocks rose. If spending 40 per cent of revenue on debt for a decade didn’t decimate Italy then, why would rising interest rates create a crisis now?
Italy’s debt could eventually become a problem, but that would require rates to soar from here — and stay there for many years, forcing the government to refinance at much higher rates. Ten-year rates between 5 per cent and 7.5 per cent from 2011-12 didn’t do that. So it seems tough to argue that yields around 3 per cent, or a touch higher, pack more of a punch.
Italian debt fear is a classic stock market ghost story. But it’s a false fear — a well-worn brick in the proverbial “Wall of Worry” that bull markets climb. False fears are always bullish. Italy will do better than feared. So will Italian stocks. Hence, so will all euro stocks. Use this false debt fear as an opportunity to buy Italian stocks, particularly big quality banks, because banks are so feared for holding debt. Snap up some bargain megabanks in Spain and the rest of Southern Europe, too, before fear fades.
Ken Fisher is the founder and executive chairman of Fisher Investments and chairman and director of Fisher Investments Europe. Twitter: @KennethLFisher
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