News of the eurozone’s demise is exaggerated, but that may not offer much comfort to stock investors.
Italy’s ongoing budget battle with the European Union finally reverberated across the rest of the eurozone last week, when Spanish, Portuguese and Greek debt joined the selloff in Italian bonds. Late Friday, Italy’s debt was downgraded another notch by ratings agency Moody’s , but the cut was minor enough that the bonds actually rallied Monday morning. Italy is still in investment grade territory.
The spread of contagion to other Southern European bond markets superficially makes sense: If investors truly thought Italy would defy European officials to the point of a forced default, the future of the entire eurozone would be seriously at risk.
However, this default scenario looks highly unlikely. Even though the EU has rebuffed Italy’s budget plans, the Italian antiestablishment government can’t push things too far because it lacks popular support to leave the euro. Long-term investors may profit from scooping up eurozone government bonds, clipping the coupons and waiting for the political noise to subside.
Yet when it comes to eurozone stocks, which are more tightly linked to economic prospects, this latest political spat should give investors pause.
The eurozone’s problem has always been about economic growth, not deficits. Between the year 2000 and now, the total amount of Italian government debt has actually expanded at a much slower pace than its peers, thanks to smaller deficits. Italian figures only look worrisome as a percentage of output because the country’s economic performance since joining the euro has been so dismal.
To be sure, Italy’s debt pile as a share of output was already very high when it joined the euro. But Portugal’s is now almost as large, with Spain and France not far behind. And none of these countries have any actual risk of defaulting as long as the European Central Bank stands behind them.
Public debts rarely come down by slashing government spending: Countries rely on outgrowing them. Italy’s budget plans are only a minor transgression that wouldn’t breach the EU’s 3% deficit rule. They could even give the economy a much-needed fiscal boost.
Right now, European officials seem ready to let slide—as they have many times in the past—over-optimistic deficit projections in the budget of the new Spanish government. Yet in Italy their instinct is to come down hard on a populist government they dislike, even at the risk of derailing the eurozone’s economic recovery, rather than seek to ease discontent through growth-oriented policies.
Global investors have long applied a discount to European equities. As long as eurozone policy makers seem more intent on delivering discipline than prosperity, that looks unlikely to change.
Write to Jon Sindreu at firstname.lastname@example.org