Author: NN Investment Partners
Politicians in Italy managed to avert the need for elections, but market attention now returns to the new populist government’s policy program.
Following a political drama in Italy that triggered a major sell-off in Italian assets last week, the country has for now managed to avoid calling new elections. Last week’s crisis and the reaction of financial markets served to underscore the Italy-related risks of a Eurozone breakup.
Peripheral treasury yield spreads widen
Source: Thomson Reuters Datastream, NN Investment Partners
Big sell-off in Italian assets
Market attention has been focused on Italian politics for the past week. In the three months that followed the country’s March elections, most watchers had been relatively calm about the outcome. The only tail risk seemed to be the unlikely possibility of a populist majority government.
Now it appears that Italy has just that. The ministers of a coalition made up of the anti-establishment Five Star Movement and the nationalist League were sworn in Friday. The installation of the new government followed a week during which a dispute between the two parties and the nation’s president made new elections seem all but certain, sparking a sell-off in Italian assets early last week.
The conflict arose when President Sergio Mattarella vetoed the appointment of Paolo Savona, an 81-year-old Eurosceptic and former industry minister, as Italy’s new economy and finance minister. Later in the week the coalition partners reached agreement with Mattarella on the appointment of economics professor Giovanni Tria to the post. The country’s leaders may have averted the threat of new elections for now, but markets will now turn their attention to the policies the populists are likely to promote and what it might mean for the future of the Eurozone.
Political drama underscore Eurozone risks
Italian politics are dominating market direction more forcefully than they have in years. The events of the past week highlighted worries over the sustainability of the European monetary union. Italy has constantly had issues regarding political instability, structural reform and high debt burdens, but only when developments start to increase the probability of a Eurozone break-up in the next 12 to 18 months do markets really start to worry. The inconclusive results of the March elections, the policies proposed by new coalition partners and last week’s political crisis all suggest that the new government is not likely to invest much political capital in reform and growth.
The new government will be led by Prime Minister Giuseppe Conte, a law professor with no political ties to Five Star or the League. Luigi Di Maio, the head of Five Star, will be the labour and industry minister. Matteo Salvini, the League’s leader, will be minister of the interior. The two party chiefs will also serve as deputy prime ministers.
Savona, whose nomination as finance minister touched off last week’s crisis, will now be minister for EU affairs. Tria, the new finance minister, has been critical of the EU’s economic governance, but unlike Savona he has not advocated a plan for Italy’s possible exit from the euro currency bloc. The government’s agenda is clearly worrisome for Brussels and for investors. A combination of more spending and tax cuts threaten to end the fiscal prudence of previous governments, turning Italy’s primary surplus into a deficit.
Italian bond yields jump
Not surprisingly, Italian equities and bonds have come under pressure. Italian government bond spreads rose to their highest level since June 2017 and the euro fell to its lowest this year against the US dollar. The weaker euro may be a silver lining for other Eurozone markets, especially for export- and USD-sensitive Germany, but for the Eurozone as a whole, Italian politics may not help investor confidence. Contagion outside Italy is limited so far. European equity indices show a positive return over the month, in line with other major developed markets.
Spreads of other peripheral bond markets such as Spain and Portugal have also increased, but less so than in Italy. Political news has also been negative in Spain, where Prime Minister Mariano Rajoy was ousted Friday in a vote of no confidence after several former members of his party were convicted of corruption. European core government bonds meanwhile benefitted from a flight to safety; the German Bund yield has fallen about 17bp. A more volatile period for Italian and perhaps also European assets may be ahead.
Coalition agreement may have reduced Eurozone risk
The good news regarding Italy may be that even a populistic government carries a lower risk of future Eurozone break-up than highly uncertain elections sometime in the future, which could have led to even more anti-establishment sentiment and less tolerance of Eurozone participation. Euro break-up risk matters most for markets in the near term. In the long term, both markets and the economy will have to digest that potential growth prospects are unlikely to brighten any time soon.
The main area of contention in Italy is the outlook for fiscal policy. Italy’s main issue is a low potential growth rate, driven by low underlying productivity growth. In order to move to a higher growth trajectory, the country needs structural reforms to bring down its 132% debt-to-GDP ratio. High public debt levels may require fiscal austerity, which is not what 5SM and the League have in mind. Full implementation of the program they agreed upon (such as billions of euros in tax cuts, additional spending on welfare for the poor, and a roll-back of pension reforms) would push the Italian deficit/GDP ratio easily to the 5-6% area, violating European rules.
The period of underperformance of Italian assets may continue. Investors had been very complacent up until the beginning of May. They were not sufficiently discounting the risk of a populist government and instead focussed on improving economic and corporate fundamentals. Consequently, investors had been increasing their positions in Italian equities, supported by strong earnings growth and a substantial valuation discount.
Underweight Italian equities
We must however not forget that the Italian equity market is sensitive to changes in the government bond spread. More than a third of the market consists of financials, a sector that was supported by improvements in the loan book. Of course, things might turn out to be less damaging, as the president has the power to veto government bills if deemed unconstitutional, or if the pressure from financial markets may become dissuasive for the implementation of measures going against the Eurozone philosophy.
Taken these elements into account, we have adopted an underweight in Italian equities at the benefit of German equities. We believe it makes sense to steer away from the problem child. German corporates may benefit from the strength of the US dollar. For the time being, we keep our neutral position in Eurozone equities. Earnings estimates are modest, and given the dollar’s strength, we may soon start to see earnings momentum moving up.