Contrasting fortunes for France and Italy predicted by Schroders’ Zangana

Azad Zangana, European economist at Schroders, says that with Greece and Spain unresolved as issues, from an austerity perspective, there may be some surprising upside risk to Italy, but downside risk to France.

Investors could be forgiven for thinking that the crisis in Europe is over. There seems to be an air of calm around the current crisis that has been absent for some time. Despite no new bail-outs, or actual new money being injected by institutions, it seems that the President of the European Central Bank (ECB) Mario Draghi has convinced markets that the ECB will back-stop the system. The 10-year government bond yields in peripheral Europe are tumbling to the lows seen in February, while European bourses have outperformed the S&P500 after severe underperformance earlier in the year. Indeed, the EuroStoxx 50 index has outperformed the S&P500 by 3.4% since the start of August, while growing confidence in peripheral Europe has helped the Spanish IBEX 35 outperform the S&P500 by 12.5%, while the Italian FTSE MIB index also outperformed by 9.1%.

Since August, we see that most of the political hurdles (the election in the Netherlands and the German constitutional court ruling on that the introduction of the European Stability Mechanism (ESM) was not in violation) have either been cleared, or deemed to be relatively low risk.

Two issues remain outstanding; Greece and Spain

Greece: Merkel has been making positive comments in Athens, ahead of the Troika’s report on Greek progress.

A report on Greece’s progress in implementing fiscal and structural reforms is being compiled by the Troika (European Commission, European Central Bank and IMF collectively). Reports suggest all parties are close to agreeing the €13.5bn worth of budget cuts, and the small number of issues around labour market reforms are close to resolution.

Greece is still waiting for its overdue €31.5bn tranche from its bail-out, but without sign-off from the Troika, then Greece must continue to wait and make do. We anticipate an agreement between Greece and the Troika to follow in the near future, largely because the Greek government must be very low on funds by now. But also, now would also be bad timing for the Troika to cut Greece off, especially with Spain occupying the markets gaze – our second outstanding risk event.
Spain continues to delay its request for a bail-out, though this seems to be politically driven by both sides.

Spain continues to delay the formal request for a bail-out that would trigger the ECB’s outright monetary transactions (OMT) bond buying programme. Markets are rife with rumours regarding the reason behind the delay, but it seems the delay may be serving all sides.

Germany appears to be using the delay to re-negotiate the policy on the recapitalisation of banks with bad ‘legacy’ assets, and the European-wide deposit insurance scheme which Merkel’s government now opposes. Meanwhile Spain’s Rajoy has benefited from the delay as his People’s Party fought local elections in Galicia and the Basque Country.

For Spain, falling bond yields have reduced the urgency for a bail-out, however the markets have moved in anticipation of the ECB making an intervention. We expect Spain to request a full or partial bailout or credit-line by the end of the year. This should trigger the support from the ECB, pushing yields on Spanish government bonds down further and providing support for the IBEX to make further gains. In addition, the start of ECB intervention could encourage Portugal and Ireland to make greater efforts to return to the sovereign debt market for financing – one of the conditions of the ECB buying government bonds.

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