Last week saw the emergence of political trouble brewing in Italy which has spilled over to the rest of the market. The turmoil in Italy began as the newly elected prime minister had difficulty forming a government. On Tuesday, Italian short-term bond yields had their biggest spike in 26 years. The turmoil in Italian bond markets also transitioned into global equity markets.
The Italian stock market was down around 5 percent last week, while the rest of European markets were down around 2 percent. This draw down in Europe has also lead to declines in American and Asian markets. The Global interconnectivity of markets has been clearly on display as this decline has spread across all markets.
The turmoil in Italy has not been and will not be a secluded event as it continues to hamper all of Europe. Currently the euro has decreased 14 percent against the dollar this year, making imported goods more expensive for the rest of the continent. Trouble in Southern European countries continue to harm the European Union — a group of 28 countries — as they fear additional bailouts.
In the past, Germany has been the scapegoat when European countries are in trouble, picking up the bill and bailing them out. However, this behavior needs to stop to ensure that growth can continue in the European Union. When Germany and the European Bank have offered funds to bail out countries before, this has led to risky loans sitting on their banks balance sheets. In some sense, these loans can be regarded as subprime because the likelihood of them being paid off becomes slimmer as more turmoil occurs.
However, German banks aren’t the only ones who should be worried. As financial institutions have looked globally in search of adequate yields in bond markets, the question arises, how exposed are these institutions to Italian bonds. It was clearly displayed on Tuesday that the whole financial sector in Europe as well as American markets flashed red.
Europe really needs to ensure that these political situations stop flowing over into financial markets, as they really cannot afford it. Europe has had its difficulties in the past and has worked hard to overcome them. All European countries will see considerably lower GDP with a weaker euro as well as less international investment. Despite that fact that big money including banks and pension funds are looking for good returns, there comes a point where the risk isn’t worth the reward.
Let’s hope that as Europeans head south for the summer that the market doesn’t follow them. Perhaps this action in Italian markets is just a hiccup and we will see a quick recovery. Although global investors should really be prepared to see volatility in global markets increase in the coming months and should to expect to see more risk.
Even some of the largest names in money management have expressed their concerns with Europe, including Ray Dalio from Bridgewater, the world’s largest hedge fund who has a $22 billion bet against European markets. Also, more recently billionaire investor George Soros, who famously broke the bank of England by betting against the pound in the 1990s, said on Tuesday that “it is no longer a figure of speech to say that Europe is in existential danger; it is the harsh reality, we may be heading for another major financial crisis.”
As we head into the heart of the summer months it is important to actively manage risk and access global markets. It is bad enough when one falls asleep in the sun and wakes up with a sun burn, seeing the markets flashing read is a more serious problem. A little bit of sunblock and a good risk protection can hopefully circumvent any problems in store.
Kenneth Kaczkowski is an equity research analyst in Munich, Germany. Isaac Maresky is a serial entrepreneur and investment banking professional with hundreds of millions of dollars of financings and M&A experience.
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