Gold Investor, July 2018

Political developments in Italy have catalysed investors’ attention over the last few weeks, as the possibility emerged that the country might leave the Eurozone, or that its new ‘populist’ government might adopt a much more confrontational stance on key EU matters, such as fiscal discipline and migrants.

The majority of Italians believe the euro has not delivered economically for the country.

The return of the so-called ‘re-denomination risk’ for Italy was apparent across financial markets. The yield differential widened between Italian and German bonds (at both the long and short end of the yield curve); equity prices fell (especially bank shares, the best proxy for the country risk) and there was an increase in insurance premia against a sovereign default (as registered by credit-default swaps).

Some even feared that Italy could trigger another global financial crisis, especially if the next general election (whenever it might occur) becomes a de-facto referendum on the country’s participation in the single currency.

Some of these tensions (and their impact on financial markets) have receded since a new government was formed at the beginning of June, but we believe this is just a temporary relief.

Why? Because Italy’s two anti-system parties par excellence, the League and Five Star Movement, have risen to power for one fundamental reason: the majority of Italians believe the euro has not delivered economically for the country.

Italy’s real GDP per capita is lower now than it was when the euro was launched in 1999. Germany’s per-capita real GDP increased by more than 25% over the same period and even Greece has done better than Italy.

The clearest indication of this perceived failure is the fact that Italy’s real GDP per capita is lower now than when the euro was launched in 1999. Germany’s per-capita real GDP increased by more than 25% over the same period and even Greece has done better than Italy, in spite of the economic depression that the country has suffered since 2008 (see Chart 1). So, Italians feel vindicated by those figures when they say that they were better off before the introduction of the euro.

They seem to have forgotten the benefits brought about by the adoption of the single currency, such as much lower interest and inflation rates, and a dramatic fall in the servicing costs of Italy’s gigantic public debt (with expenditure on debt interest collapsing from 12% of GDP to 5% or below). They seem to regret the fact that the loss of monetary sovereignty means it is impossible to resort to periodic currency devaluations as a way of re-gaining competitiveness lost because of the many inefficiencies of the Italian system. These include labour market rigidities, low public and private investment in research and development, unbearable levels of tax evasion and avoidance, intolerable levels of public and private corruption, dysfunctional and costly public administration and legal system.

When confronted with the choice of remaining in or leaving the single currency (which could happen via a general election in which the central debate is exactly that), Italians might initially decide to stay, fearing the costs of a solitary exit, which they could start to experience even before the vote – as a few people would probably start to withdraw money from their bank accounts, as the Greeks did between 2012 and 2015. However, over time Italians might be tempted to leave the Eurozone, feeling that they have what it takes to stand successfully on the global economic stage, including a still-large industrial sector that could export worldwide.

If even a fraction of the new government’s promises were to be included in the budget for 2019, a new collision course with the EU, and the market, will become almost inevitable.

If this analysis is correct, the ‘Italian issue’ will soon be back on the European discussion tables: perhaps as early as September, when the new government will need to draft the budget that has to be sent to Brussels, before the national parliament can approve it by December. The new ‘government contract’ includes promises such as the introduction of a flat tax system, a minimum income policy and a backtracking of the pension system reform introduced by former Prime Minister Mario Monti in 2012. If even a fraction of these were to be included in the budget for 2019, a new collision course with the EU, and the market, will become almost inevitable, particularly if the rating agencies were to downgrade Italian debt to one notch above ‘junk’.

Gold will remain a crucial component of diversified portfolios, as a hedge against potential corrections across asset classes.

What are the implications for financial markets and asset allocation? Some of the extreme moves observed in the last few weeks (falling equity prices, spikes in short- and long-term rates and yield spreads, a rise in CDS premia and so-called ‘ISDA spreads’) could become apparent again, especially if the redenomination risk were to re-appear on investors’ radar screen. In terms of asset allocation, we have suggested for some time that investors adopt a ‘moderate risk-taking stance, within a defensive positioning’, implying quite a large weighting to sovereign bonds and illiquid assets such as private equity and real estate, while being effectively neutral on equities. In this context, gold will remain a crucial component of diversified portfolios, as a hedge against potential corrections across asset classes.