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A Brewing Storm

Just as the dust started to settle with political stability somewhat mitigated and investors focus now on corporate earnings as a means of justifying high global valuations, Italy comes to the forefront. European markets have performed strongly and valuations are becoming stretched so that even the smallest shock would likely see equity markets weaken the question is to what extent? Italy, known for its political instability, high debt and resulting drag on the European Union is in desperate need of effective leadership and structural change. The political parties of Italy recently announced that they are in the process of coming to an agreement on new electoral law that, if successful, will almost certainly lead to early elections this September. The announcement on May 16th saw markets deteriorate slightly, primarily in Italy where the FTSE MIB fell 2.31% followed by two falls of 2% on May 26th and 29th as the news unfolded. The most significant decline was in Italian Mid Caps which fell 2.51% led by financials. However, the relatively sober response suggests investors believe there is a low chance of a populist party being elected and subsequently an Italexit.

The Italian and German bonds spreads widened as the yield on an Italian 10yr government bond hit 2.18% (a 6.77% increase). The change in spread represents an increase of 188 basis points. Citigroup predicts spreads to widen further to as much as 300 basis points, levels that haven’t been seen since 2013.

 

German Bund / Italian BTP 10 year Yield Spread

Bund BTP Spread

                Source: Bloomberg

 

With the recent win of Emmanuel Macron as French President and the likely triumph of Chancellor Angela Merkel the Euro currency has been the stronger major currency, a further reflection perhaps that most investors currently place a very low probability of a populist triumph.

Should Italy’s political parties come to accept an electoral reform it is likely to take a shape similar to that of the German model; proportional representation with a 5% threshold. Considering this, and looking closely at the most recent election polls, only four of the political parties make the 5% threshold. The PD and 5SM stand at 30% each, Forza Italia and Northern League in the low teens and no party is on course to win a majority so a coalition is almost certain. Currently, consensus seems to suggest a coalition between PD and Forza Italia (both pro-EU parties) however 5SM and Northern League should not be ignored. Both are anti EU and would call a referendum. Should this coalition become likely, we would expect to see a big sell off in markets.

In conclusion, there are a few immediate obstacles to observe. The state of the Italian economy is the first and will most definitely play a part in influencing the outcome of the election. Support for the 5SM seems to rally whenever news of Italy’s economic performance turns for the worst. Initial economic reports this year have been promising with strong results coming from boosted inventories and consumer spending. If this continues, Italians may rally behind the PD. Secondly, poll predictions will likely influence markets and be a good indicator as to the possible outcome of the elections. Looking back at the Italian referendum, polls were fairly accurate in forecasting the vote and so investors will expect this to follow through in the elections. Finally, keeping a close eye on the interaction amongst parties. If the 5SM and Northern League form a coalition, it is very likely they could win the election. The result will see devastating effects to the markets. We remain cautious in the short term upgrading risk to ‘medium’.

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