Equity, credit markets shudder over Italian political turmoil
The political upheaval in Italy is rattling global markets and investors as it forces European stocks down and pushes bond yields higher.
Italy's two main anti-establishment parties could unite to form a government, a move that would end the political impasse and remove the need for a new election in July. In response to the overnight developments, European markets staged a mini-bounce from one of their worst sell-offs in years.
The euro was down 0.3 per cent on Tuesday, while stocks in Milan slid 2.6 per cent on the main index after a 2.1 per cent fall on Monday. Bank shares slumped another 5 per cent, having lost 4 per cent in the previous session, bruised by the sell-off in government bonds, a core part of Italian banks' portfolios, according to newswire AAP.
However, reports that Italy's populist Five Star Movement (M5S) and the far-right anti-immigration League could merge rather than force another election helped end a five-day losing streak for Milan-listed equities.
"Similarly, short-dated Italian bond yields – a sensitive gauge of political risk – fell almost half a per cent from half-decade highs after suffering their worst day in nearly 26 years on Tuesday," AAP reports.
Fidelity International
Ahead of the latest developments, Alberto Chiandetti and Andrea Iannelli, from Fidelity International's equities and fixed income teams, respectively, said:
"With hindsight, we may look back to the current turmoil and investor capitulation as a great buying opportunity. For now, however, it’s difficult to choose the best time to catch the proverbial ‘falling knife’.
"The recent turn of events, unprecedented in Italy and in most European countries, has led to a constitutional crisis with elected parties challenging the role and remit of the President. The next elections will be very polarised with the vote becoming a view on Europe and on the country's political establishment."
Chiandetti says "the Italian equity market, the darling of Europe in the past two years, has given up all of its outperformance against broader European indices over that period, with bank stocks in particular taking a hit."
In fixed income, Italy's government bond yields have "jumped, and spreads over their 'safer' German equivalents have risen, with some contagion to Spanish and Portuguese bonds," says Iannelli.
"All Italian fixed income assets are suffering but sovereign bonds (BTPs) more so than corporate bonds, possibly due to the higher liquidity in the former, both in cash and futures, which makes them a preferred vehicle to hedge broader country risk held in credit portfolios.
Chart 1: The end of Italy’s equity market outperformance?
Source: Thomson Reuters, Fidelity International, May 2018.
"The situation remains extremely fluid and markets will continue to trade at the mercy of headlines and announcements. Italian assets will clearly trade with a high beta and the country's high debt-to-GDP ratio leaves little room for manoeuvre on the deficit, keeping investors wary.
Rising yields will certainly be an unwelcome development for an issuer with such a high debt burden, and markets can act as "automatic stabilisers" should the fiscal stance become untenable.
Not entirely negative
On the growth front, Iannelli says the current instability will see this "stall, if not reverse, some of the more meaningful reforms recently implemented" though economic conditions are not as strained as they have been in the past.
"Domestic investors hold a larger share of the nation's debt than a decade ago, and the ECB is now a stable buyer of Italian sovereign bonds, of which it owns a not insignificant 14 per cent.
"Economic growth has been positive since 2013, the current account deficit has been in surplus for five years, and the fiscal deficit has more than halved since its 2009 peak.
"Corporate fundamentals have improved considerably in the past year, and the national champions among Italian banks have worked hard to improve their capital position, selling non-performing loans and improving profitability and margins," says Iannelli.
Chart 2: Improving GDP growth since 2013
Year-on-year GDP growth. Source: Thomson Reuters, Fidelity international, May 2018.
JP Morgan: Italy 'as stable as a bowl of jelly'
A bemused Kerry Craig, global market strategist, JP Morgan, notes Italy is now into its 66th government since becoming a republic in 1946, "meaning the country averages a new government every 13 months … the government is about as stable as bowl of jelly".
"All this political uncertainty in Italy raises the spectre of the 2012 Eurozone crisis and is rattling markets beyond the country's borders. Markets fret because the shift towards a populist government in Italy has the potential to be much more damaging given the size of Italy's economy, debt burden and bond market."
He notes Italy is 15 per cent of the Eurozone economy, making it the third largest but with a debt to GDP ratio of 130 per cent. "Contrast this to Greece, which is the only economy to have a larger debt burden of 176 per cent debt-to-GDP, but is less than 2 per cent of the Eurozone economy. Then there is the debt market itself.
A silver lining
For all the concern, Craig echoes Fidelity's Iannelli in saying Italy is potentially "less of a threat to the Euro project than it once was".
He points to Italian polls that show support for the euro currency is stronger than in recent history, with an increasing number of Italians viewing it positively. "As with many of the European elections since the crisis, the outcome of elections have been more about instigating a change in the political system, rather than simply about leaving the single currency bloc."
Craig also believes the overall euro regions recovery will continue, with sginficant capacity to grow. "There is still a significant amount of economic repair to be done and capacity to be used up before the cycle ends. The unemployment rate in the US is at its lowest in decades, but in the eurozone it’s yet to fall to pre-crisis levels.
More favourable equity market valuations in the eurozone – where post-GFC economic recovery started later than other regions and so is earlier in the cycle – also mean longer run returns could be better than many other regions.
"Based on expected returns from our Long Term Capital Market Assumptions research, Eurozone equities could be one of the best performing asset classes over the next decade," he says.
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Glenn Freeman is senior editor at Morningstar Australia.
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