European politics is back in the headlines. It has been three years since the final stages of the Greek debt crisis. It has been two years since Brexit. It has been a year since the French elections, and nine months since the German elections. Each of these events raised investor anxiety over the spread of populist sentiment, including euro skepticism. And each time, that anxiety subsequently receded as the worst fears of each outcome were mostly avoided.

Now we turn to Italy, where it has been just under three months since the national election that was dominated by the populist Five Star and League parties. Both had expressed their own skepticism about Eurozone membership during the campaign, but had ultimately toned down that rhetoric and set about attempting to form a coalition government. However, on Wednesday, May 16, a draft economic proposal from the working coalition revealed proposals for sovereign debt forgiveness by the European Central Bank (ECB), sizeable fiscal stimulus despite an already bloated debt burden, and the creation of procedures to allow member states to leave the monetary union. Italian government bonds immediately began to sell-off. By Friday, May 18, the yield on the Italian ten-year note had climbed 27 basis points to 2.22 percent. The final version of the coalition economic plan released on May 18 had dropped the debt forgiveness proposal, as well as the proposal for a pathway to exit the Eurozone, but that did little to stem the rising concern among investors.

Last week, on Monday, Italy’s president rejected the coalition’s proposal to appoint a Eurosceptic economic minister and instead appointed a former International Monetary Fund (IMF) official as prime minister to form a technocratic interim government, raising the likelihood of another round of elections. In his speech announcing the decision, President Mattarella said the economic ministry, “Always constitutes an immediate message of trust or alarm,” and that he could not accept a minister who may provoke Italy’s exit from the euro, noting that, “The uncertainty over our position has alarmed investors and savers.” On Friday, Moody’s Investor Services placed Italy’s Baa2 sovereign debt rating under review for a possible downgrade. Such an action, if incremental, would leave the rating just one grade above junk, a threshold below which many investors would become sellers. By Tuesday of this week, the ten-year note yield had soared to 3.10 percent.

In its April 2018 Fiscal Monitor report, the IMF warns that, “High government debt can make countries vulnerable to rollover risk … and market access could be disrupted if … there is a shift in investor sentiment. A high debt-to-GDP ratio could cause a spike in risk premiums if investors become skeptical about a country’s ability or willingness to pay -- including because of concerns with the political feasibility of fiscal policies … Indeed, in a number of countries debt is above levels at which fiscal crises occurred in the past.” Italy’s debt-to GDP ratio is currently at 130 percent, and under existing policy is expected to decline slowly. (Germany’s, in contrast, is 64 percent, and the overall Eurozone level is 87 percent). Italy’s fiscal outlook has improved, as debt service costs have declined and it enjoys a current account surplus. But the concern is that the coalition’s fiscal proposals would abort this progress and worsen the country’s already problematic debt burden.

The weakness in Italian bonds has spilled over into equity prices as well. In the two weeks since the coalition’s draft economic proposal was released, Italy’s FTSE MIB index has dropped 12.5 percent, dragging the EuroStoxx 50 index lower by 3.7 percent. And the already falling euro has extended its decline. This latest bout of turbulence will no doubt impact how the European Central Bank manages its current quantitative easing program, and some are already suggesting that it may have to be extended well beyond its current pledge.

As Italy attempts to sort out its path forward, Spain is also experiencing its own political turmoil. The current administration is subject to a vote of no confidence this Friday, following accusations of corruption in the ruling party.

And if all of this wasn’t more than enough for investors to consider, the economic calendar in the U.S. this week is full of market moving reports, including the May jobs report, revision to first quarter GDP, April personal income and spending and Personal Consumption Expenditures (PCE) deflator, pending home sales and ISM manufacturing.

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Past performance is not a guarantee of future results.
The FTSE MIB (Milano Indice di Borsa) is the benchmark stock market index for the Borsa Italiana, the Italian national stock exchange. The index consists of the 40 most-traded stock classes on the exchange.
The EURO STOXX 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Supersector indexes, from which members are ranked by size and placed on a selection list. 
The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis (BEA).
The ISM manufacturing index is a national manufacturing index based on a survey of purchasing executives at roughly 300 industrial companies.
The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.
Indexes are unmanaged and are not available for direct investment.
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