Italy’s latest political-economic-monetary crisis, which is rattling the financial markets, provides investors with yet another opportunity to learn how to react to the latest news headlines.
That’s because Italy’s troubles [1]aren’t the first time in which countries, under the burden of too much debt [2]and restrictive fiscal and monetary policies, threaten to break free of the currency regime — in this case the euro EURUSD, -0.0520%[3] — in which they have been operating. Invariably following those prior crises, stock investors reacted with alarm[4], but more often than not the stock market quickly recovered and soon was trading for more than where it stood prior to the crisis erupting.
Read: Try this high-flying commodity to resist the fallout from Italy[5]
Also: George Soros explains his audacious plan to save Europe[6]
Perhaps the most spectacular recent illustration of this was the stock market’s reaction to the United Kingdom’s June 2016 referendum to exit the European Union (a.k.a “Brexit”). The Dow Jones Industrial Average DJIA, -1.58%[7] dropped almost 1,000 points in the two trading days following the vote. But after just eight subsequent trading sessions, the Dow was higher than where it stood before the Brexit vote.
The market’s reaction to other currency crises wasn’t always this swift, of course. And there are major differences between the British situation then and Italy’s today, not least of which is that Italy’s economy is far weaker than the U.K.’s. Regardless, the U.S. stock market’s typical reaction to currency crises is surprisingly close to the pattern seen in the wake of the U.K.’s Brexit vote.[8][9]
Consider the market’s reaction to the debt crisis Greece experienced beginning in late 2009, since it is that crisis that many believe is most analogous to Italy’s. Over the subsequent several years, you may recall, a series of urgent fiscal and monetary deals were struck between the Greek government and the stronger European economies and the International Monetary Fund. The ever-present threat hanging over all those negotiations was that a Greek exit from the euro (a.k.a. “Grexit”) would precipitate a domino effect, bringing down the entire European Union.
Even so, the U.S. stock market over time rose significantly in the wake of that looming threat. And it’s not just 20:20 hindsight for me to point this out. I regularly predicted that it would occur, beginning with a column in March 2010[10], just a few months after the Greek debt crisis became front-page news....