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Eurozone Outlook: When Secular Turns Cyclical

In Europe, the secular risks appear to be materializing more quickly than expected, particularly in Italy.

Over the next few years, financial markets could be set for a series of “Rude Awakenings,” as we forecasted in our latest Secular Outlook. The global economy is transitioning out of a post-crisis period characterized by remarkable stability, and the changes ahead could be jarring for investors.

In Europe, this forecast appears to be unfolding already.

Among the key secular risks we identified in our outlook are the emergence of a radical populist backlash against capital, the establishment and free trade; a shift in the policy mix toward fiscal expansion; a market environment characterized by less reliance on central banks; escalating geopolitical conflict; and a likely global recession in the next few years.

In Europe, Italy recently elected a radical anti-establishment government that intends to engage in significant fiscal easing just as the European Central Bank (ECB) is retreating from asset purchases. Geopolitical risks are on the rise, as the ongoing immigration and refugee crisis shows. And the still-fragile design of the currency union leaves the region very exposed to downside risk when the next recession hits.

Not only do the secular risks we highlighted look relevant for Europe, but they appear to be materializing more quickly than expected, particularly in Italy, and spilling over into the near-term, cyclical horizon.

Italy at the forefront

Just days after our Secular Forum ended in early May, Italian government bond (BTP) yields jumped more than 100 basis points (bps) to around 250 bps over those of German bunds, and have hovered there for weeks. The rise came as anti-establishment parties Five Star Movement (M5S) and the League forged an alliance around a program entailing a very large fiscal easing package and the possible introduction of a parallel fiscal currency. Importantly, an early version of this program also backed the introduction of mechanisms in Europe that would allow sovereigns to exit the currency union. And the administration in Italy appointed some clear euroskeptics to key ministerial and senior staff posts.

As market volatility spiked, the new Italian government sought to reassure investors, but the damage was done. The euro-exit genie has been released from the bottle, and the government’s fiscal plans contrast sharply with Finance Minister Giovanni Tria’s recent assertion that public debt should be reduced.

Rising political risk in Italy comes against the backdrop of a currency union with a less-than-solid infrastructure. Macro convergence efforts across core and periphery countries in the eurozone have remained insufficient, and the region lacks the fiscal and financial stabilization mechanisms that would mitigate the impact of the next downturn. The EU summit in June was another missed opportunity in this regard, with major decisions on regional integration postponed again. Progress now looks difficult given divergent views among member states on important issues such as common deposit insurance and a eurozone budget.

What about the ECB?

As the only truly federal institution in the eurozone with significant financial firepower, the ECB has been the glue holding the region together. But investors may not be able to count on the ECB in the same way going forward for several reasons. First, the ECB’s asset purchase program is coming to an end, and restarting it may not be entirely straightforward given political opposition to the program in several countries. Second, the shift in ECB leadership in autumn 2019 raises uncertainty. Third, the ECB would likely find it hard to quell market stress by purchasing sovereign bonds if that stress comes from governments’ euroskeptic ideologies and fiscally irresponsible actions. Last but not least, fiscal capacity is unevenly distributed across the eurozone, and common fiscal instruments, such as the European Stability Mechanism, are currently too small to accommodate the potential needs of large countries like Italy.

All in all, the eurozone faces a challenging outlook over the secular horizon, which appears to be spilling over into the cyclical horizon. We think this calls for caution when investing in eurozone periphery sovereigns and risk assets more broadly, and supports our secular investment theme of giving up some yield potential in exchange for portfolio flexibility.

For more on Europe and the global economy, please see our Secular Outlook.

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The Author

Nicola Mai

Portfolio Manager, Sovereign Credit Analyst

Andrew Bosomworth

Head of Portfolio Management, Germany

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