Never mind Brexit, political chaos in Italy could be the fatal blow for European unity

David Brown says current European unity is largely a reaction to Brexit and will eventually fade, with new turmoil on the cards thanks to the end of the ECB’s stimulus and Italy’s political uncertainty

PUBLISHED : Monday, 21 May, 2018, 2:24pm
UPDATED : Monday, 21 May, 2018, 10:24pm

You could have been forgiven for thinking Europe was a trouble-free haven of stability. After all, investors have flooded into its capital markets chasing a glut of super-stimulus from the European Central Bank, economic recovery has flourished and political problems seemed a thing of the past. Even Greece has been welcomed back into the global lending club. European unity has never seemed better. 

It’s time to take off the rose-tinted spectacles. 

Little has changed. The problems keep piling up and Europe is wading into troubled waters again. Bulled-up stock market investors are having doubts about the durability of Europe's recovery once the ECB winds down its stimulus programme. There is even growing talk about a future hard landing once the ECB’s gravy train grinds to a halt. Economic confidence is already taking a dive with euro-zone consumers and businesses fretting about life after zero interest rates and quantitative easing. 

Policy differences are already beginning to rankle. European unity has been a shining beacon in the past couple of years as the European Union has closed ranks against Britain’s Brexit plans. In reality though, European unity is a chimera. Once Brexit hostilities move backstage, there are deeper problems waiting in the wings, rekindling a return to the bad old days of European uncertainty, political backbiting and discord. 

Once Britain is out of the door, the risk is that Europe turns in on itself again. The question is who’s next in line for hard-line treatment. Weaker euro-zone economies could easily end up in the firing line. Scrape underneath the surface and investors will find little has changed. 

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Greece might have been welcomed back into Europe’s fold, but the experience of harsh bailout terms and dire austerity has been a bitter pill to swallow for most Greeks. Anti-Brussels sentiment runs high and the chances of a future political backlash against the euro zone cannot be ruled out. Greece is on a very long road to recovery and the pain from years of deep debt restructuring may be too much to bear. Greece remains close to tipping point. 

Considering the problems Greece posed for the euro’s survival, imagine the potential chaos caused by a much larger European nation like Italy getting into similar trouble. A major credit event in Italy would be the nightmare scenario posing the mother of all existential threats to the euro. The huge scale of Italy’s public and private indebtedness would be too great for Europe to handle, overwhelming even the ECB’s seemingly endless resources. 

An Italian debt default would be a nuclear disaster for world financial markets. It would not only be game over for the euro, but would drag investors into another downward spiral of global contagion. And it is not so far-fetched considering Italy’s current political malaise

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Investors are justified to feel rattled about the prospect of the next Italian government formed by the populist, anti-establishment Five Star Movement and the far-right Lega. The coalition bears all the hallmarks of a marriage made in hell for European stability. Pledging to roll back domestic austerity measures, cancel Italian debt and repatriate migrants would be anathema to the EU and send Italy into a head-on collision with Brussels. It could even mark the beginning of the end for European unity. 

No wonder worried investors are dumping Italian assets. The bellwether 10-year Italy-Germany government yield spread has already shot up to a six-month high of 170 basis points, with the potential to go a lot higher on the upside if selling turns into a rout. Past threats by Lega to quit the EU and dump the euro should be taken seriously, so a return for the 10-year spread to a 600-800 basis point range cannot be ruled out. 

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The euro may be looking stable right now, but investors should be warned that European markets could be entering very dangerous waters if the Italian political situation gets super-critical. Italy has a history of unstable governments but this particular mix could prove extremely treacherous for investors. 

European stock markets are vulnerable, the euro could fall quickly out of favour and German bund yields could sink even further into negative territory on knee-jerk safe haven plays. If Italy boils over, European markets could be heading into summer chaos.

David Brown is chief executive of New View Economics