18 September 2017 Long•Term Asset Return Study: The Next Financial Crisis Italy: A crisis waiting to happen? A country nearing an election and with high populist party support, with a generationally underperforming economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings ticks a number of boxes to us for the ingredients of a potential next financial crisis. Independently, Italy has been dealing with each of these issues for some time. Recently the country has been able to tolerate high debt levels with insulation from aggressive ECB QE and subsequent ultra-low global bond yields. Government dysfunction is also relatively well engrained with sixty-five governments having ruled since WWII, with parties united and subsequently separated in often short lived coalitions, albeit never including the then Italian Communist Party which has arguably been one of the main populist parties before the 5SM was established. 'Figure 44: Italy Government Debt to GDP 140% 120% - 100% . 80% 60%• 40% 20% • 0% ban 19131 Sauce Arumlm Oar{ rover 11101 1971 931 bre 1 2001 However the next twelve months could see Italy arrive at a crucial juncture which will help dictate the medium-term road ahead. With an election looming, populist anti-euro support in Italy is hovering just above 45%. The timing of the election will also likely coincide with reduced ECB buying of BTPs and should Eurozone inflation rise (especially if Italian inflation remains weak), then the threat of rising BTP yields without a sustainable improvement in economic growth will likely test the limits of Italy's already elevated debt to GDP. Debt sustainability remains the biggest medium term problem and leaves Italy very exposed to a recession, in our view. Assuming limited tailwinds from structural growth, this places a huge burden on the need for cyclical growth. While the recent cycle has been strong, th