Italy On The Brink

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According to the New York Times, Italian credit default swap rates have more than tripled in cost since the summer. As of Monday, the annual cost of ensuring a $10 million five-year Italian debt bond was already a cool $511,000.

The PowerShares DB Italian Treasury Bond Futures ETN (NYSEArca:ITLY) has fallen 6.16 percent since Monday. If you held the PowerShares DB 3X Italian Treasury Bond Futures ETN (NYSEArca:ITLT), you’ve lost a whopping 18.09 percent this week.

By now, the 7 percent level on a 10-year bond has become foreboding in the eurozone, simply because interest rates on such loans become too costly for a cash-strapped government to properly repay. Greece, Ireland and Portugal breached that threshold early in Europe’s sovereign debt crisis, and one after another sought bailouts from the International Monetary Fund and others. Will Italy follow in their footsteps?


Past As Prologue?

Take Greece. As yields on Greek 10-year notes rose, the MSCI Greece Index tanked. You can see that sovereign debt yields started rising right around April 2010, or the time of the initial bailout.

It looks like, when the spread between the bond yield and total return becomes too wide—investor confidence is shot.

Greek 10-year notes


Source:Bloomberg

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In late 2010, when talk of default began swirling in Portugal, the spreads between bond yields and total returns on 10-year Portuguese debt behaved much as they had in Greece.

Portugal 10-year debt


Source:Bloomberg

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The question now is whether this will also happen in Italy. For now, its spreads have not moved to the same ominous levels as they have in Greece and Portugal.


Italy spreads

Source:Bloomberg

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Maybe it is because Italy is wealthier.

Also, while government debt and spending have been high, both have remained relatively stable since Italy joined the eurozone in 1999.

So, where’s the fire?

To begin, total national debt as a proportion of GDP is massive, and second only to Greece in the eurozone. That says something, especially considering the fact that Italy is the fourth-largest economy in Europe and the eight-largest in the world.

Moreover, Italy’s economic growth has been sluggish in the past decade, averaging .28 percent per annum. In contrast, France has grown more than four times as much, at an annual average of 1.14 percent. (France is an apt comparison in part because both have populations of approximately 60 million.)

It’s unlikely that Italy’s growth will explode overnight. According to the Bank for International Settlements, the average company in Italy has less liquidity than its international counterparts. Furthermore, the Italian economy is plagued by a low birth rate and high life expectancy—a combination that cripples future growth, caps labor supply and fuels sky-high social welfare spending.

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Defending The Core

Since Italy is culturally and economically a core EU member, it is likely that German and French officials will bend over backward to save it. Although Italy’s economy is too big for the EU to bail it out by itself, European officials have said they’re not above accepting aid from China.

Due to the interconnectedness of the global economy, a default in Italy would reverberate horrifically throughout the world. To those of you who thought that Greece’s dictating of stock prices in the last few weeks was powerful—that was just a tease compared with what could happen with Italy.

It seems to me that the real question isn’t whether the government will seek a bailout—Italy will ask for it and receive it. Instead, it is a question of what Italian officials will do with the loans that will determine how fast or slow the nation will climb out of the hole it dug itself into.

In the late-1990s, the Asian financial crisis drove investors West, but eventually the Asia-Pacific economy recovered. Although a final solution to Europe’s sovereign debt crisis seems far away, perhaps now is the time to buy cheap and hold.

Deep-Value ETFs

For ETF investors, about a dozen funds that provide equity exposure to Europe are available, and they’re likely to be heavily discounted while this Italian drama plays out.

Among today’s most popular options are the Vanguard European Fund (NYSEArca:VGK) and the iShares S'P Europe 350 (NYSEArca:IEV).

For the more risk-averse, owning German equities using iShares MSCI Germany (NYSEArca:EWG) and Market Vectors Germany Small-Cap (NYSEArca:GERJ) might make sense.

There’s also a low-cost currency-market play, which is likely to remain prospective as long as the fates of Greece, Italy and other eurozone countries remain in a limbo.

The CurrencyShares Euro Fund (NYSEArca:FXE) could be used tactically as a shorter-term trading vehicle, or strategically. To buy-and-hold investors:Make sure you believe in the euro and its long-term future before committing to FXE for the long haul.

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Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 IndexUniverse LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.




This article appears in: Investing , ETFs

Referenced Stocks: EWG , FXE , IEV , ITLT , VGK

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