Italian budget standoff raises sell-off fears

The Italian market sell-off looks set to continue following a rejection of the first budget proposal yesterday.

Italian flag
Source: Bloomberg

Italian politics have been one of the biggest drivers of uncertainty within the eurozone in 2018, with fears associated with the new coalition government raising risk aversion throughout the region.

That coalition is formed of two populist parties, with a general anti-establishment and Eurosceptic theme running through both. With the coalition built on a pledge to end austerity, shifting the emphasis shift away from keeping the European Union (EU) happy and instead focusing on doing right by the everyday person.

However, this fiscal expansion raises fears of a potential ramp up in the debt burden currently seen in Italy, alongside a potential increase in tensions with the EU. The debt issue is one critical concern for the EU given the fact that Italy has the second highest debt-to-gross domestic product (GDP) level (130%) in Europe . With treasury yields rising over growing concerns, we are seeing the price of servicing their ballooning debt rise further.

Yesterday we saw the European Commission (EC) reject the latest Italian budget, raising the possibility of sanctions being placed on the Italians. That 130% debt-to-GDP level is more than twice the limit set by the EU, thus reducing the likelihood that any budget which raises the deficit would be passed.

The Italian coalition is standing by their plans and refuses to reduce spending, yet with the EU unlikely to budge, we are set for an impasse which will dent confidence for some time yet. With Five Star Movement leader, Luigi Di Maio, having previously declared that Italy would 'no longer satisfy rating agencies and financial markets while stabbing Italians in the back', there is plenty of reason to believe European and, in particular, Italian markets could suffer for some time yet.

Looking at the Italian FTSE MIB 40 index, we can see another month of losses look almost certain, building on the downturn seen since topping off at the historical resistance level of 24,568. Things look highly likely to persist over the coming months, with a move into the potential trendline or a drop into the range bottom of 12,338 coming into play.

We are also seeing Italian bonds fall in price, raising the value of their yield. That is a reflection of falling interest in putting money into a government which wants to ramp up borrowing when already heavily indebted.

The hurdles faced by both sides in finding an agreement when both are so heavily entrenched in their positions means we are likely to see Italian treasuries fall further. The risk of a ramp up in Italian debt means markets will be increasingly fearful of the chance that Italy will fail in the event of another recession, with contagion risks raising the likelihood of a eurozone-wide crisis.

Looking at an Italian bond exchange traded fund (ETF), we can see that the weakness seen over the past five months has broken us out of an uptrend and into a more bearish phase. However, with no clear support level of note to watch out for on this wider chart, further losses seem likely. A break above 15,213 would bring about a more bullish outlook.

Where could we go from here?

With the European Commission (EC) having rejected the latest Italian budget, we are faced with a standoff where one side has to shift their position. While the Italian coalition cites the fact that 16 of 28 EU states currently have debt higher than the 60% debt-to-GDP threshold, it is unlikely that this will shift the EU stance.

There is a strong chance that the EU will impose punitive measures should we see the Italians fail to shift their stance, raising market worries. Should we see any movement towards a positive conclusion then this would shift the emphasis towards a more optimistic stance for the FTSE MIB 40 and Italian treasury prices.

However, with this issue likely to get worse before it gets better, there is little reason to believe we have reached the bottom quite yet.

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