The Political Crisis in Italy Revives Bad Memories in the Euro Zone

International issues have grabbed investor attention in recent months, from threats of trade wars to efforts to build closer ties with North Korea. The decision by the United States to impose new sanctions on Iran and Venezuela also contributed to the recent spike in oil prices to levels not seen in several years. The U.S. president's unorthodox style has undoubtedly contributed to escalating geopolitical uncertainties. A surge in concern over the political situation in Italy, however, reminds us that Europe is also facing substantial challenges.

The March 4 elections in Italy were rocked by the spectacular strides made by left- and right-wing populist parties. Initial results suggested that an impasse had been reached, forcing a new round of elections to be held. International investors did not seem terribly concerned by this situation, which pointed to maintaining some semblance of the status quo. Everything changed suddenly in mid-May when the possibility emerged of an agreement between two parties that had garnered about 50% of the vote, i.e. the Five Star Movement and the League.

Italy thus appeared poised late in May to adopt a government controlled by two parties with opposing social and economic viewpoints, but with a common populist and Euro-sceptic vision that was in direct opposition to Italy's traditional parties and Europe's institutions. The program put forth by both parties called for major public spending and tax cuts. Fears of a sharp deterioration in Italy's public finances and a confrontation with leaders of the European Union, particularly on the migrant issue, drove Italian bond yields — and default insurance costs — higher. Bond yields in other peripheral countries were also under some pressure. as were bank securities. The corruption scandal that caused the fall of the Spanish government did not help.

The Italian situation took an even more worrying turn when Italy's president refused to accept Paolo Savona as the nominee for the position of Minister of Economy and Finance, as he was deemed too Euro-sceptic. At that point. a new round of elections seemed inevitable. Such elections would have been held in a very tense environment, as populist movements were galvanized by the president's actions, which they judge anti-democratic. Investor fears thus continued to surge, and the impact started to be felt on financial markets around the world. At the end, a compromise was found to allow the establishment of a government led by the populist parties, but the situation will likely remain tense in the coming months.

In many ways, the recent events in Italy are a throwback to the sovereign debt crisis that gripped the euro zone at the beginning of the decade. For the moment, however, it does not look as though financial strains will be as tense as they were at that time. The improved economic backdrop and measures put forth by the European Central Bank (ECB) should help limit the contagion, especially given the low risk of Italy dropping the euro for good. Because of the size of its economy and public debt, as well as its fragile banking system, Italy represents nonetheless a substantial risk that needs to be watched closely. This should convince the ECB to be very prudent moving forward, and it could very well opt to extend its sovereign bond purchases if tensions fail to dissipate quickly. This could keep the euro at a relatively low level.

Beside the current volatility, the troubles in Italy are a reminder that the euro zone is still facing several challenges. The ECB's forthright actions a few years ago may have prevented the worst case scenario but they did not solve the fundamental problems, such as the precarious finances of some countries and financial institutions and the absence of the population's support for a more integrated European model, which would improve economic coordination. Investors interested in this part of the world must keep in mind that these issues will likely continue to subject European markets to some measure of volatility over the next few years.