Are The Markets Right About Italy?

Includes: EWI, FXE, ITLT, ITLY
by: Desmond Lachman

One has to wonder about the wisdom of global markets with respect to its pricing of Italian government bonds. Since it would seem to be that nothing now causes the market to revise its presently rosy assessment of the Italian government's ability to repay the mountain of debt that it has borrowed. Never mind that Italy shows every sign of political dis-functionality or that the German constitutional court might have cast doubt on the Outright Monetary Transactions program, the European Central Bank's safety net for the European periphery in general and for Italy in particular. And never mind that Italy struggles to emerge from its worst post-war economic recession and now flirts with outright price deflation. Italian government bonds keep rallying in the market as a result of which the Italian government now can borrow at the lowest interest rate since the onset of the Eurozone debt crisis in early-2010.

Matteo Renzi's ouster of Enrico Letta as prime minister should hardly be a cause for market celebration. Rather, it should be seen as yet another sign of Italian political weakness. Mr. Renzi is now the fourth Italian prime minister in the past two years and he is now the third successive Italian prime minister who has not been elected at the polls. He also will have to work with the same weak coalition government and the same divided Italian parliament that had prevented the Letta government from achieving any real progress in the area of structural reform. And perhaps of equal concern is the fact that Matteo Renzi, who was Italy's great hope for a fresh start for the country, might have tarnished his public credibility by coming to power through the backdoor..

All of this would not be of the greatest moment if the Italian economy were in good shape. Sadly, however, this is far from the case. Italy's government debt now exceeds 133% of GDP and there is little prospect that this debt will stabilize anytime soon. After all, for all intents and purposes Italy remains mired in a deep recession and it is on the cusp of price deflation. Compounding matters is the fact that with Italian youth unemployment in excess of 40% and with little prospect of it declining anytime soon, there is the real danger that Italy's recent political fragmentation as evidenced by the rise of the Five Star movement will continue. Should that indeed occur, the country will become even less governable than before.

Evidently markets do not share the pessimism expressed above about Italy's longer run economic prospects. But then until very recently markets were very upbeat about the economic prospects of the emerging markets' so called Fragile Five countries only to revise that view at the first hint of Federal Reserve tapering. Only time will tell whether the markets are right in pricing Italian bonds as if the country had resolved its debt problem. However, all the clues seem to be pointing in the direction of the Italian government at some stage needing a major debt restructuring.