Over the next few years, financial markets could be set for a series of “Rude Awakenings,” as we forecasted in our latest Secular Outlook. The global economy is transitioning out of a post-crisis period characterized by remarkable stability, and the changes ahead could be jarring for investors.
In Europe, this forecast appears to be unfolding already.
Among the key secular risks we identified in our outlook are the emergence of a radical populist backlash against capital, the establishment and free trade; a shift in the policy mix toward fiscal expansion; a market environment characterized by less reliance on central banks; escalating geopolitical conflict; and a likely global recession in the next few years.
In Europe, Italy recently elected a radical anti-establishment government that intends to engage in significant fiscal easing just as the European Central Bank (ECB) is retreating from asset purchases. Geopolitical risks are on the rise, as the ongoing immigration and refugee crisis shows. And the still-fragile design of the currency union leaves the region very exposed to downside risk when the next recession hits.
Not only do the secular risks we highlighted look relevant for Europe, but they appear to be materializing more quickly than expected, particularly in Italy, and spilling over into the near-term, cyclical horizon.
Italy at the forefront
Just days after our Secular Forum ended in early May, Italian government bond (BTP) yields jumped more than 100 basis points (bps) to around 250 bps over those of German bunds, and have hovered there for weeks. The rise came as anti-establishment parties Five Star Movement (M5S) and the League forged an alliance around a program entailing a very large fiscal easing package and the possible introduction of a parallel fiscal currency. Importantly, an early version of this program also backed the introduction of mechanisms in Europe that would allow sovereigns to exit the currency union. And the administration in Italy appointed some clear euroskeptics to key ministerial and senior staff posts.
As market volatility spiked, the new Italian government sought to reassure investors, but the damage was done. The euro-exit genie has been released from the bottle, and the government’s fiscal plans contrast sharply with Finance Minister Giovanni Tria’s recent assertion that public debt should be reduced.
