What s Going on in Italy?

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1 WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS What s Going on in Italy? October 16, 2018 Peter Donisanu Investment Strategy Analyst Key takeaways» Global financial markets have been rocked by concerns about financial stability in Italy (among other things). Italy s budget challenges have increased speculation about eurozone contagion risks.» We believe that Italy-related volatility is tied to market participants extrapolating a worst-case scenario into the future. In our view, it is not necessarily reflective of a financial crisis in the present. What it may mean for investors» While the risks are growing, we believe that Italy will continue to service its debts and that the likelihood of its problems spreading to the rest of the eurozone are limited in the near term. As such, we consider this view to be supportive of market sentiment in international risk assets. Market participants have grown increasingly worried about Italy in recent weeks. One factor contributing to the broad market sell-off came last month as the Italian government presented a preliminary budget to European Union (EU) leaders that called for tax cuts and more spending in an environment of ballooning government debt and structural weakness in Italy s financial sector. This situation added another brick to a wall of worry that market participants have been climbing in recent months. Yet, we do not believe that this latest development will lead to a eurozone-wide financial crisis in the near term. Chart 1. Government debt as a percent of GDP Italy has a debt problem 180% 133% 126% 102% 98% 104% 99% 63% 64% 66% 67% 35% Italy Germany France Greece Spain Portugal 3/31/2018 3/31/2008 Sources: Wells Fargo Investment Institute, Eurostat; October 11, GDP = gross domestic product Wells Fargo Investment Institute. All rights reserved. Page 1 of 5

2 Italy s debt problem Italy has a debt problem, and its EU partners would like it to address that problem sooner, rather than later. The size of Italy s government debt relative to its economy has grown from 100% of gross domestic product (GDP) in 2008 to 130% of GDP in Ongoing Italian-government assistance to a banking sector still ailing from the global financial crisis adds to these challenges. The EU s budget position is focused on getting Italy to address its spending habits, so it can begin to reduce its debt load or (at the very least) slow its accumulation. This is a position also held by private sector creditrating agencies. Just as the creditworthiness of a household declines when it spends above its means, some credit-rating agencies have threatened to downgrade Italian debt to junk status if it implements its proposed budget. When Italy s issues are taken together, markets have a lot to worry about, and the recent market volatility suggests that participants are extrapolating a worst-case scenario. This scenario could include a credit downgrade that likely would prevent further Italian debt accumulation or forced institutional selling of positions in lower-quality Italian debt. Lower demand for Italian bonds would push yields higher, increasing borrowing costs for the country when it is already struggling to balance its books. It also could limit Italy s ability to respond to future banking crises. There is speculation that Italy s debt challenge may lead some Italians to consider leaving the eurozone. However, such a decision would be so costly in terms of inflation and lost credit access that it seems to be a remote possibility. Chart 2. Yield spreads versus 2-year German bunds suggest that eurozone bondmarket concerns have been contained to Italy 2500 Spread versus German bunds (basis points) Height of the eurozone debt crisis Italian elections and budget standoff Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 France Spain Portugal Ireland Italy Sources: Wells Fargo Investment Institute, Bloomberg; October 11, Past performance is no guarantee of future results. 100 basis points equals 1 percent Wells Fargo Investment Institute. All rights reserved. Page 2 of 5

3 Investment implications While the risks are growing, we believe that Italy will continue to service its debts and that the likelihood of its problems spreading to the rest of eurozone are limited in the near term. From a contagion perspective, yield spreads versus German bunds appear contained compared to 2011, suggesting that bond markets are not worried about systemic risks spreading to other countries yet (Chart 2). We would grow increasingly worried about eurozone contagion risk if these yields were to widen (rise) as they had seven years ago. We also believe that systemic risks are likely to be limited, given continued accommodative monetary policy in the eurozone and the fact that the European Central Bank (ECB) has the tools necessary to address contagion risk. For now, market volatility in Italy appears to be driven in part by politics and by the standoff between the Italian government and the EU. We believe that appetite for risk assets will return to international markets once we get past the Italian budget showdown. For now, disagreements about these budget discussions likely will introduce uncertainty, contributing to bouts of volatility in financial markets Wells Fargo Investment Institute. All rights reserved. Page 3 of 5

4 Economic Calendar Date Country Report Estimate Previous 10/16/2018 AUSTRALIA Westpac Leading Index MoM % 10/16/2018 US Industrial Production MoM % 10/16/2018 US Net Long-term TIC Flows -- $74.8b 10/16/2018 US Capacity Utilization % 10/16/2018 US NAHB Housing Market Index /16/2018 US JOLTS Job Openings /16/2018 GERMANY ZEW Survey Expectations /17/2018 EUROZONE CPI YoY % 10/17/2018 AUSTRALIA Unemployment Rate % 10/17/2018 US MBA Mortgage Applications /17/2018 US Housing Starts k 10/17/2018 US Building Permits k 10/17/2018 US FOMC Meeting Minutes /18/2018 UNITED KINGDOM Retail Sales Ex Auto Fuel MoM % 10/18/2018 JAPAN Natl CPI YoY % 10/18/2018 US Initial Jobless Claims /18/2018 US Leading Index % 10/18/2018 US Philadelphia Fed Business Outlook /18/2018 US Continuing Claims /19/2018 UNITED KINGDOM PSNB ex Banking Groups b 10/19/2018 US Existing Home Sales m 10/19/2018 US Existing Home Sales MoM % 10/22/2018 JAPAN All Industry Activity Index MoM % 10/22/2018 BRAZIL Trade Balance Weekly /22/2018 US Chicago Fed Nat Activity Index /23/2018 MEXICO Economic Activity IGAE YoY % 10/23/2018 EUROZONE Consumer Confidence /23/2018 JAPAN Nikkei Japan PMI Mfg /23/2018 US Richmond Fed Manufact. Index Source: Bloomberg, as of October 12, Wells Fargo Investment Institute. All rights reserved. Page 4 of 5

5 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 5 of 5