Market sentiment has shifted to risk-off
Italy’s proposed coalition government collapsed over the weekend after the president refused to accept euroskeptic Paolo Savona as minister of finance. Markets have since reacted, with Italian government bond yields rising above their eurozone counterparts. Unsurprisingly, with the possibility of another election in the cards, market sentiment has shifted to risk-off in light of the political uncertainty.
Three questions for Italy going forward
Against the backdrop of the latest polling data, it is really hard to predict what will happen next in the political arena. The latest poll of polls shows how Lega (League) has gained popularity at the expense of Forza Italia, and that the 5-Star Movement (M5S) has lost some momentum lately. This makes it hard to predict what both Lega and M5S really want at this juncture:
- Does Lega want to capitalize on their improvement, or do they want to hold out in the hopes of being able to challenge M5S for the top spot?
- Does M5S really want new elections, given they would have to change every candidate (or change their bylaws)?
- And finally, what will the official return of Silvio Berlusconi mean now that he is again allowed to run for office?
We don’t have answers to these questions. Only time will tell.
Looking over the longer term – What could happen next?
What happens over the next year or two will determine not only what Italy’s relationship with the eurozone and its institutions will be, but it will also determine whether or not current market pricing provides investors with a potential opportunity.
With this in mind, we’re keeping a close eye on the following topics:
We continue to believe that risk to Italy’s membership in the eurozone is limited. The euro still has the support of roughly 60% of Italians, and both Lega and M5S have noticeably toned down their euroskepticism. Even more, President Sergio Mattarella is clearly trying to protect Italy against anti-euro moves.
Whether it happens now or after elections in July or August, most roads lead to a coalition government of M5S and Lega. Of course, this can change quickly given how volatile Italian politics is, and we believe that neither the Democratic Party (PD) nor Forza Italia should be discounted. However, for now we are focusing on what a coalition with Lega and M5S could actually get done, as opposed to what they want to do. We continue to believe that the constraints imposed by both President Mattarella and financial markets will force a new government to tone down its fiscal plans significantly.
The European Central Bank (ECB)
The ECB might have an important role to play, but only if things worsen significantly from here. At that point, it will have to assess the situation and determine whether the risk to the eurozone is such that it needs to provide support – or whether it needs to teach Italy a lesson. Given Italy’s importance and size, we suspect it will choose the former and provide support to specific banks using Emergency Liquidity Assistance (ELA). Or, it may be via the financial system in general through new LTROs (long-term refinancing options) and an extended quantitative easing program. However, we only expect this to happen if Italy slides into a crisis that threatens the eurozone’s overall recovery.
We believe that the risk of a doom-loop (i.e., where increased sovereign risk weighs on the banking sector and starts a vicious downward cycle) is real, but not as large as many fear. Italian banks are, by and large, quite well-capitalized, and it would take a very big decline in government bond prices before they would be at risk of insolvency.
What’s in the cards for financial markets?
From a valuation and sentiment perspective, Italian bonds are now considered cheap and oversold. On the other side of the equation, German Bunds are now overbought and expensive. Italian equities have only recently pushed into oversold territory and are not yet considered particularly cheap. The Italian yield curve has flattened dramatically over the past few days and…