European markets edgy on Italian turmoil as ECB ponders urgent meeting

The surge in German inflation complicates the European Central Bank’s life even further, says ING Bank economist Carsten Brzeski:

While the Easter Bunny Effect has finally been left behind, German inflation is still heavily affected by seasonal effects. The sharp surge in oil prices in combination with several public holidays and long weekends pushed up energy prices, leisure costs and food prices. Under the surface of (too) many one-off factors, German inflation data still tells a two-sided story: while prices for consumer goods have gradually accelerated in recent months, inflation on services has slowed down and has even been negative for a couple of months for communication and clothing. Where available, core inflation measures at the state levels actually dropped in May.

Despite today’s increase in headline inflation, the underlying trend still points to a rather benign picture for inflationary pressure. For the ECB, however, today’s inflation data from Germany gives a foretaste of the increased complications on the road to taper. The still undecided debate on whether the Eurozoneeconomy is in a soft patch or at the start of a protracted downswing, the surge in oil prices and latest political developments in Italy have clearly complicated the ECB’s life. It increasingly looks as if the big question for the ECB is not when to stop QE but rather when to signal an extension of QE. With latest market turmoil and political tensions in Italy, giving some certainty in times of uncertainty could be the ECB’s preferred policy choice. This would be an announcement or at least a very clear hint at QE extension at the June meeting.

Despite many markets edging higher, they are nowhere near recovering the Italy-driven losses, and investors have very little appetite for risk at the moment. Craig Erlam, senior market analyst at Oanda, said:

It looked as though we were headed for fresh elections as early as July, with negotiations between Five Star Movement and Lega having failed after President Sergio Mattarella vetoed their choice of Finance Minister. Carlo Cottarelli – a former IMF economist – was tasked with forming a temporary government until further elections are called, ideally next year, but that appears to have failed before it got started.

While early elections will arguably be very beneficial to the populist parties, who will cite the rejection of its choice of Finance Minister as evidence of Brussels interference and an abuse of the democratic will of the people, it seems one last attempt to form a government is being discussed. The parties seem unwilling to hold an election in July and have no desire to wait until next year.

If a government can be formed that receives the stamp of approval from Mattarella and is therefore seen as not posing a threat to Italy’s place in the eurozone, then this will come as a relief to markets in the near-term. Longer-term risks remain though and both parties will likely use recent events as a platform to drum up opposition to the euro with the end goal of holding its own referendum, something eurozone leaders will understandably fear after the UK result in 2016.

Over in Spain, prime minister Rajoy is resisting the idea of stepping down as he prepares to face Friday’s no confidence vote:

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AFP news agency

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Spanish Prime Minister Mariano Rajoy rules out quitting ahead of a no-confidence vote in parliament over graft convictions against members of his Popular Party
http://u.afp.com/ogBk 

4:16 PM – May 30, 2018

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• Don’t panic, suggests Paul Donovan, chief economist at UBS Global Wealth Management:

• Everyone needs to take a deep breath and calm down. Only then can we talk about Italy.
• 1) Bond market moves do not break up monetary unions. Bank runs do. There is no evidence of bank runs.
• 2) Neither Italian parties nor Italian voters support leaving the Euro.
• 3) The anti-party coalition was not expected to last, because of policy disagreements. It is not certain that the two anti-parties would try to form a government after elections.
• Markets have moved anyway. We are now in that phase where any trader who overheard a conversation in their local Domino’s Pizza takeaway considers themselves an expert on Italian politics. Investors would be wise to treat recent market moves with caution.

The Lega party reportedly wants new elections in Italy as soon as possible. Reuters says:

Italy’s far-right League party will not block rapid political solutions that would allow the country to handle possible emergencies, but it wants an election as soon as possible, a source from the party said on Wednesday.

“At this point, we will not block rapid solutions capable of managing emergencies, but we must let Italians express themselves again as soon as possible,” the source said.

The source did not explain what was meant by “emergencies”, though financial markets have been in turmoil over the continuing political uncertainty.

Europe is likely to muddle through the current political uncertainty, says Erin Browne, head of asset allocation at UBS Asset Management:

Without a swift political solution to the situation in Italy, we believe that the risk-return trade-off for European assets has deteriorated. As things currently stand, we are likely to see a period of heightened volatility in Italian and broader European equities and bonds amid Italian political dynamics and their interactions with ECB policy.

That said, we do not see Italian political developments as presenting material systemic risks beyond Europe at this stage. Both populist parties have signalled they will not attempt to leave the Eurozone (and according to the Italian Constitution this would be extremely difficult in any case), even if their desired fiscal policies put them on a collision course with the core of Europe and the ECB.

We ultimately expect market and political pressures to constrain these parties, and Europe will find a way to muddle through political uncertainty as it has in the past. Still, we recognize the path to resolution is likely to be bumpy and have downgraded our outlook on European assets to account for recent developments.The Italian bond auction results are in, and it seems to have been a reasonable success although the interest rate is again a high one:

The dip in the eurozone sentiment figures shows that even before the Italian turmoil, confidence was not really recovering, says Bert Colijn, senior eurozone economist at ING Bank:

Much like fidget spinners, euphoria about Eurozone growth and politics is definitely something that stayed in 2017. A few months ago, the sky was the limit for Eurozone sentiment, but now even stabilisation seems like a good result, as analysts expected worse.

Given that the survey does not account for the Italian turmoil, it’s safe to say that moderating growth continues to be the message of 2018. While a few one-offs impacted the disappointing first quarter growth rate of 0.4%, it seems that there is some more permanence to the slower growth than initially expected even though Eurozone fundamentals remain strong with labour market strength and a favourable investment environment.

The months ahead will likely see uncertainty continue as the Italian political crisis could drag on during the summer. As developments towards a new government continue, uncertainty about the Italian stance towards the EU and the euro will prevail. Even though it is very unclear what the next steps will be, markets have clearly woken up from the euro-risk lull that started after the Macron presidential election victory in France last year. This continued uncertainty will weigh on Eurozone growth in the months ahead, and a bounce back to growth rates seen in 2017 seems very difficult.

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Eurozone economic sentiment slips

Economic confidence in the eurozone dipped slightly in May, according the European Commission.

The economic sentiment index slipped by 0.2 points to 112.5 in the eurozone, but edged up 0.4 points to 112.8 in the wider EU. Consumer confidence in the eurozone was down from 0.3 to 0.2. The commission said:

Virtually unchanged consumer confidence (-0.1) was the result of a marked decrease in consumers’ assessment of the future general economic situation, which was counterbalanced by a strong increase in their savings expectations. Views on households’ future financial situation and unemployment remained broadly stable.