June 8, 2018

News in Charts: Italy – Calm After the Storm

by Fathom Consulting

Recent events have reminded us all that a week is indeed a long time in the world of Italian politics. Fears that new elections were imminent sent markets briefly into turmoil, causing the largest one-day increase in Italian yields since the inception of the euro. Although some of this has since unwound heightened volatility is likely to remain.

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Equities took a battering, with banking stocks particularly affected. In the case of Italy, Fathom’s Financial Vulnerability Indicator (FVI) has been flashing red for some time — relative to its own historic average, Italy has now risen to third in the list of countries most vulnerable to a banking crisis. This is unsurprising given the banks’ high stock of non-performing loans and large holdings of the sovereign’s debt.

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Moreover, the government’s elevated debt burden means that it is not just fears of a banking crisis that should trouble those investing in Italy’s economy. Indeed, Italy’s debt-to-GDP ratio is second only to Greece. This means that, despite the country running a reasonably sized primary surplus, high debt servicing costs ensure that the government’s overall budget balance remains in deficit.

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Consequently, the trajectory of Italy’s public debt remains highly sensitive to changes in the country’s funding costs, a point that Fathom laid out to clients in a recent note. Indeed, while the spread of Italian bonds over their German counterparts remains relatively low, it is unlikely that this will remain the case going forward.

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Despite this, markets currently see the odds of an Italian default as slim — Fathom calculates that the market-implied probability of default within the next five years averaged 8% last month. Separate Fathom calculations suggest that, on a daily basis it remained close to 10%, even amidst the recent market sell-off. However, investors were at times much less certain of the country’s continued membership of the euro, with a second Fathom indicator showing that the market-implied probability of an exit briefly rose to 20% last week before falling back.

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Nevertheless, there appeared to be a limited degree of contagion with bond yields barely budging in peripheral countries such as Spain and Portugal. Fathom indicators also show that the market-implied probabilities of default remained low in May for all countries bar Greece.

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