Geopolitical issues have had a significant impact on investment markets this year, and despite the noise, it’s not just factors relating to President Trump and the US.
There is an ongoing fear that the formation of a populist coalition Government in Italy with Eurosceptic leanings will drive a crisis in that country that could potentially threaten the future of the Eurozone.
While the populists did not fare as well as many predicted across Europe last year, they certainly did in the March elections in Italy this year; where the left-leaning Five Star Movement (5SM) and far-right Northern League (NL) were the big winners.
This unusual Eurosceptical coalition has proposed amongst other things: big tax cuts (with just two rates of 15% and 20% for companies and individuals); a basic income for the less well-off; a rollback of pension reforms; and a review of European Union budget rules.
The resultant budget deficit blow-out will undoubtedly create tensions with the EU at a time when Italian public debt is the second highest amongst Eurozone countries, at around 130% of GDP, and its budget deficit is the third highest, at around 1.6% of GDP.
Many Australian investors are keeping an eye on Italy because of the impact any potential volatility in the Eurozone could have on the markets globally and here.
There are four main factors to consider in relation to Italy and the Eurozone. The first is that question marks over Italy’s commitment to remaining part of the Eurozone will weigh on the value of the Euro compared with the USD and other major currencies.
A rise in the Euro through last year - as Eurozone growth surprised on the upside relative to the US and political risk declined in the Eurozone relative to the US - harmed Eurozone shares. This is now reversing as US growth has started to accelerate relative to the Eurozone.
The second is that Eurozone shares are likely to be relative outperformers globally, helped by more attractive valuations than the US.
Eurozone shares are trading at a price to forward earnings multiple of 14 times which is around its long-term average. Their cyclically adjusted price to earnings ratio which compares share prices to a ten-year moving average of earnings (often called a Shiller PE), is around 17 times compared to 32 times in the US. This is largely because Eurozone shares underperformed US shares in the post GFC period.
Adjusting for relatively lower bond yields in Europe makes Eurozone shares even more attractive.
Thirdly, monetary policy in the Eurozone is easier compared with the US. The European Central Bank is still pumping cash into the economy and is a long way from rate hikes.
Italian risk may keep the ECB easier for longer. This contrasts with the Fed which is engaging in quantitative tightening and raising interest rates.
Finally, while Eurozone growth has slowed a bit it’s still good, and thanks to ongoing monetary stimulus and a now falling Euro it is likely to remain so. In turn, this is good for profit growth.
Bringing this all back to the initial point about the future of the Eurozone, I think it is not in grave danger.
Last year, the big concern was that the 2016 Brexit vote and Trump victory presaged a surge in support for populist Eurosceptic parties in elections in the Netherlands, France, Germany and Austria and that an independence vote in the Catalan region of Spain would also pose a threat, all contributing to increased risk of an eventual Eurozone break up.
In the end, no such thing happened.
Popular support for the Euro is solid at over 70% across the Eurozone and various countries showed by their elections last year they aren’t interested in exiting the Euro.
But while a break up in the Euro is unlikely, a populist coalition in Government in Italy, which is the Eurozone’s third largest country, along with a deterioration in its budgetary position will keep fears of a threat to it alive. This will likely cause sharemarket volatility and weakness in the Euro.
And in the meantime, Eurozone shares remain attractive.
So, what’s all this got to do with Australian investors? Simple – as we saw earlier this decade and up until the last round of Grexit (a Greek exit of the EU) worries in 2015 whenever there are significant concerns about a break-up of the Euro it affects global investor confidence. This in turn, impacts Australian investment markets.
In the meantime, be a bit wary of Italian assets but the Eurozone share market overall remains attractive.
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