How A Banking Crisis In Italy Could Impair European And Global Portfolios

| About: Vanguard FTSE (VGK)

Summary

Markets fear that a defeat of constitutional reforms proposed in Italy’s Dec. 4 referendum would end the government of Prime Minister Matteo Renzi.

The reforms aim to make it easier for governments to implement their programs.

Using MSCI’s stress-testing capabilities, we have evaluated two scenarios that could unfold following such an outcome, to help investors quantify and manage the possible impact on their portfolios.

By Carlo Acerbi, Risk and Regulation Research, MSCI

Markets fear that a defeat of constitutional reforms proposed in Italy's Dec. 4 referendum would end the government of Prime Minister Matteo Renzi, who has promised to resign if they fail. The reforms aim to make it easier for governments to implement their programs. A failed referendum could produce political instability, which could complicate efforts to recapitalize the country's struggling banks, impede the government's ability to reform the economy for the long term and increase risk across Europe, already engulfed by a banking crisis.

Using MSCI's stress-testing capabilities, we have evaluated two scenarios that could unfold following such an outcome, to help investors quantify and manage the possible impact on their portfolios. Below we summarize each scenario.

Scenario 1: An Italian banking crisis with moderate spillovers

Markets fear that rejection of reforms in Italy will thwart the government's efforts to secure a rescue plan for Italian banks, which are weighed down by non-performing loans. Banks default en masse, triggering a severe economic recession in the country. Though the crisis spreads to the rest of Europe, with an acute impact on countries at Europe's periphery, investors perceive that governments and the European Central Bank have managed to limit the risk of further instability.

Equities in Italy lose nearly a third of their value over ensuing weeks, while stocks in developed markets fall 7.4% (see shocks below). The VIX jumps by about 35%. The crisis pushes Italy and countries at the periphery of Europe closer to default, as yields on Italy's six-month and 10-year government bonds increase 240 basis points and 110 bps, respectively.

Portfolio Implications:

Equity and sovereign bond markets at Europe's periphery could fall 22.4% while stocks world-wide could fall 8%, reflecting uncertainty about growth (below chart). Government bonds at Europe's periphery tumble 8% on fears of defaults.

Cyclical equity sectors could lose 9.2%. Among equity factors tied to economic growth, value and small cap could lose 13.7% and 12.8%, respectively. Defensive sectors and factors such as quality and minimum volatility would lose 7% and 6%, respectively.

Fixed-income portfolios with longer durations and a tilt away from peripheral Europe and high yield do better, falling about 2%.

A diversified global multi-asset-class portfolio could lose as much as 5.2% of its value. Despite its tilt toward global bonds, a risk-parity portfolio could still lose 4.8%.

Scenario 2: A European banking crisis that causes investors to question the future of the euro and the EU

Investors worry that banks burdened by nonperforming loans will require a combination of bailouts and bail-ins, in which borrowers and their creditors both take losses. Investors lose confidence in the ability of the ECB and eurozone leaders to end the crisis, which raises the risk of members of the currency union defaulting on government debt.

The banking crisis becomes systemic and spreads widely, with the most acute impact falling on an already fragile European banking sector. Prospects for a severe recession and an increase in political instability intensify questions about the future of both the EU and the euro.

The VIX jumps by 70%, reflecting a significant uptick in risk. Equity markets fall as much as 12.6% across developed markets. Financials in Europe lose nearly 30% their value. As markets perceive greater risks of sovereign default, sovereign-bond yields rise across maturities and across Europe except for Germany. Italy's 6-month and 10-year bond yields increase 310 bps and 190 bps, respectively.

Portfolio Implications:

Equity and sovereign bond markets at Europe's periphery could fall 25.6% while stocks world-wide could fall 13%, reflecting uncertainty about growth. Government bonds at Europe's periphery tumble 12.4% on fears of defaults.

Cyclical equity sectors and factors could lose 14.4%. Among equity factors tied to economic growth, value and small cap could lose 22.9% and 21.5%, respectively, while defensive sectors and factors such as minimum volatility and quality likely could outperform the market. A global diversified fixed-income portfolio could experience losses of about 3%.

A diversified, global multi-asset-class portfolio could lose nearly 9%. While mitigating the impact, a risk parity portfolio could still lose 8.1%.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information contained herein (the “Information”) may not be reproduced or redisseminated in whole or in part without prior written permission from MSCI. The Information may not be used to verify or correct other data, to create any derivative works, to create indexes, risk models, or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. None of the Information or MSCI index or other product or service constitutes an offer to buy or sell, or a promotion or recommendation of, any security, financial instrument or product or trading strategy. Further, none of the Information or any MSCI index is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The Information is provided “as is” and the user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF MSCI INC. OR ANY OF ITS SUBSIDIARIES OR ITS OR THEIR DIRECT OR INDIRECT SUPPLIERS OR ANY THIRD PARTY INVOLVED IN MAKING OR COMPILING THE INFORMATION (EACH, AN “INFORMATION PROVIDER”) MAKES ANY WARRANTIES OR REPRESENTATIONS AND, TO THE MAXIMUM EXTENT PERMITTED BY LAW, EACH INFORMATION PROVIDER HEREBY EXPRESSLY DISCLAIMS ALL IMPLIEDWARRANTIES, INCLUDING WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. WITHOUT LIMITING ANY OF THE FOREGOING AND TO THE MAXIMUM EXTENT PERMITTED BY LAW, IN NO EVENT SHALL ANY OF THE INFORMATION PROVIDERS HAVE ANY LIABILITY REGARDING ANY OF THE INFORMATION FOR ANY DIRECT, INDIRECT, SPECIAL, PUNITIVE, CONSEQUENTIAL (INCLUDING LOST PROFITS) OR ANY OTHER DAMAGES EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited.