Investors have reacted to the uncertainty by withdrawing $10.6 billion from European equity ETFs
Volatility and risk could persist in Europe for some time
The focus for many at the moment is European politics. Italy, Spain and trade tensions between the United States and the European Union are at the forefront of investors’ minds. European equities are down about 3 per cent since their May highs.
On the economic front, latest Europe Purchasing Manager's Indexes have come in soft, in fact, even if in line with estimates they were down from April levels (54.1 versus 55.1), although Germany saw positive revisions and the Spanish composite PMI at 55.9 was higher than in April and above consensus.
The Italian PMI beat expectations and was flat versus April, a good reading considering the political uncertainty. Retail sales in the eurozone were up only 0.1 per cent in April and below the consensus (0.5 per cent), though the March number was revised upwards by 0.3 per cent. Latest German and French Industrial Production fell significantly versus both expectations for rises as well as positive numbers for last month.
This year, there has been $10.6 billion in outflows from European equity exchange-traded funds, according to Bloomberg, as investors have reacted to uncertainty in the region. German and Italian ETFs saw the greatest redemptions.
The situation in Italy has been evolving daily over the past few weeks. Markets reacted to the uncertain situation with two and 10-year BTP government bond yields spiking to 2.78 per cent and 3.16 per cent respectively. Now, two-year yields have come back to lower levels though are still very elevated considering they had been negative until mid-May.
Equity markets were also affected as the Italian market had, unexplainably in our view, been the best performing market in Europe until it gave back all its gain during government formation talks. The euro also felt the brunt of the situation touching a low of 1.15 versus the dollar. The move in Italian yields has been extremely large and while one could debate at length what the fair value of Italian bonds should be - and that perhaps a negative two-year yield was not fair value - the broader mis-pricing of European sovereign yields is a wider issue affecting the whole European government bond market, which has been suppressed by years of quantitative easing and a negative deposit rate.
The government in Italy has now been formed, and Prime Minister Giuseppe Conte has already hinted at fiscal spending that would have a large effect on the country’s deficit and elevated debt levels. The situation in Italy will likely continue to cause volatility for some time but there seems a very low likelihood of an exit from the eurozone as the freshly appointed Finance Minister, Giovanni Tria, has explicitly stated.
While it would be auspicious to have greater dialogue among European leaders and institutions to accommodate the very different situations in which member states are in, an exit from the EU or its currency would have drastic consequences. Recent polls still show that the majority of Italians are in favour of the euro membership. The population would not willingly be able to tolerate years of disastrous economic conditions following an exit from the euro.
While the populist parties that formed a government seem to have tempered their rhetoric on exiting the euro, some of the fiscal proposals floated would result in a massive budget increase - which would break EU rules on fiscal deficit. Though, over time these parties have changed their rhetoric often and quite significantly, so it’s very difficult to speculate on what policies they would enact and on the certainty and timing with which these could be able to pass approval. Some measures, if thoughtfully structured in a less budget costly way, would be positive, among these for example the restructuring of the Italian multi-layered tax system which results in an extremely high level of taxes for individuals.
While Italians displeased with the economic situation and political parties now at the helm of the government put most of the fault on Europe, Italy’s problems go far beyond that. Italy should start focusing on its long-standing issues: poor productivity, low competitiveness with one of the lowest rankings in Europe for ease of doing business, an intricate bureaucracy, high tax evasion, an inefficient public sector which could benefit from some privatisation, a complex tax system, a stale labour market and an extremely high level of government debt and NPLs. Realistically tackling these problems would enable Italy to grow strongly again. While the list seems long, as Italy has the ability to face these difficulties, it just needs a strong willingness for change instead of just for protest.
In Spain, after Mariano Rajoy lost a no-confidence vote, Pedro Sanchez, leader of the Socialist Party, took over as prime minister. While the reforms announced by the populist party do not appear business or euro friendly and could bring short- to medium- term volatility, markets in Spain seem to have not priced this in significantly. On the economic front though Spain has a more solid foundation than Italy and in fact has seen much better growth.
Finally, trade tensions between the US and China as well as other regions, such as Europe, are also negatively affecting economic sentiment.
At the end of the last week, talks from European Central Bank members on tightening monetary policy, contracting German and French IP data, Donald Trump’s exploits at the G7 forum and contagion from emerging market equities all contributed to a selloff in developed markets, the most of which was seen in Europe with Italy and Spain the worst performing markets.
Given all of the above, volatility and risk could persist in Europe for some time. We prefer to take a cautious stance and are currently avoiding direct positions in European equities (outside of Switzerland). We are finding better value elsewhere as we see better upside and visibility in US equities alongside some more idiosyncratic opportunities.
Ilaria Calabresi is a vice president at JP Morgan Private Bank