At Davos, Anxiety Over Global Markets Focuses on Italy

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As the world's political and business leaders network at the annual World Economic Forum meeting in Davos, Switzerland, the crisp Alpine air is not the only thing giving them the shivers. Since the new year, pre-eminent economists have lined up to pronounce 2016 the riskiest year for financial markets since 2008.

China's economic slowdown is overlapping with greater geopolitical risks around the globe. China's foreign exchange reserve figures released at the start of the month revealed the extent of the country's battle with capital outflows, now estimated at $676 billion over the course of 2015. Emerging markets, formerly Davos darlings, are now struggling with China's slowdown and the low price of oil, a commodity the sale of which has kept many of them afloat.

Meanwhile, everyone is watching tensions build among European states and awaiting the agitation that will ensue across Europe when warmer weather brings renewed migrant flows through the Balkans. And with the U.S. Federal Reserve having raised interest rates in December 2015 and the European Central Bank and Bank of Japan continuing to pursue quantitative easing, markets have to cope with divergence among the key central banks for the first time in many years. All of these aspects have combined to make markets somewhat nervous, and Wall Street equities have had their worst start to a year in their history.

The question here is whether we should care about traders' nerves. Share prices go up and share prices come down—what effect do they have on actual events? One answer is: sometimes very little. Quantitative easing has shown how artificial stock market valuations can be. With central banks pumping out money, the various stock exchanges have enjoyed an extended period of roaring good health, based not on their companies' superlative performance but more because there is so much money floating around that has found a home in equities. Market panics can look foolish once the initial reaction has worn off; in August, a poorly communicated 2 percent devaluation of China's yuan led to frantic sell-offs around the world, but traders bought stocks back once it became clear that losses in China's stock market had little contagion danger and the yuan was not dropping any further—at least not immediately.

A second answer to the question, though, is that sometimes share prices affect actual events quite a lot. The global financial system rests on fractional reserve banking, in which money is created when the economic climate is positive and destroyed when it is negative. Whether the climate is positive or negative depends largely on the popular mood, which theoretically is determined by the facts. Positive developments can breed an exuberant atmosphere, encouraging investors to bid prices upward, far beyond their normal levels. The flip side comes when new facts emerge, suddenly changing the atmosphere to one of fear as the same investors race to get assets out of their hands before the value drops further. This is the danger of investor sentiment, and if mishandled—as it was following the 1929 Wall Street Crash—it can lead to extended financial woe for entire populations.

In the current period of uncertainty, Italy—particularly its banks—appears to be the victim of the moment. The Italian banking index is down 17.7 percent this year, and Italy's third-largest and most historically troubled bank, Monte dei Paschi, has lost 50 percent of its value during the same period. The most dramatic drops have taken place this week. The Italian stock market regulator has deemed it necessary to ban short selling on Monte dei Paschi stock in an attempt to prevent speculators from benefiting by driving it lower, yet it continues to fall.

As is so often the case with the markets, these actions are rooted in fact but with a layer of sentiment on top. Italy's banks are indeed troubled; their nonperforming loans amount to more than 200 billion euros (about $218 billion), and Monte dei Paschi had an extremely weak balance sheet long before a 2013 derivatives scandal dealt it another blow. But these nonperforming loans have been growing ever since 2008, and that growth has slowed of late. Italy's banking crisis has long been brewing, and the markets appear to be taking it seriously for the first time since European Central Bank President Mario Draghi defused the last market panic by promising to do "whatever it takes to save the euro" in mid-2012.

Either way, the market sell-off could seriously damage Italy's economy. New regulations brought in at the start of the year heighten the risk of a bank run because investors and depositors must now bear the pain of an Italian bank going bust. This is a strong incentive for a bank's depositors and investors to move their funds elsewhere if they believe the bank is in danger (sentiment plays a role again), and there are reports that Monte dei Paschi depositors are doing just that.

Italy and the European institutions must now look for ways to reverse the sentiment that is making Italian banks the victims and reassure the markets of the banks' safety. The drastic way of achieving this would be a government bailout, but this is unlikely both because of the new rules and because bailouts typically occur when a crisis is in a more developed state. Another way would be persuading another Italian bank to buy Monte dei Paschi and take on its risky assets at a discount, thereby reassuring the market that Italy's largest problem is now solved. This is possible in theory, though the travails of banks that bought their weaker peers in the crisis of 2008 might make it a hard sell for potential suitors.

The final possibility, which is more of a hope than anything, would be that the global markets' tricky January will turn out to be just that, and that the world will enter February in the somewhat calmer state of mind in which it ended December. For that to happen, the markets would need some good news and perhaps some soothing words out of those movers and shakers meeting in the rarified airs of the Swiss Alps. But with the structural changes that are now in place, China's struggles likely to worsen, oil prices unlikely to rise and a wave of migrants awaiting their cue to enter the Balkans, hope for that kind of improvement is probably misplaced.

At Davos, Anxiety Over Global Markets Focuses on Italy was originally published by Stratfor, a geopolitical intelligence and advisory firm based in Austin, Texas.

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