Market Comment - Italian elections: risk or opportunity?

News item -

On Friday, Matteo Salvini, Italian Interior Minister and leader of the right-wing populist League party, pulled the plug on his coalition government. Italian assets, especially government bonds, suffered a major setback. We expect the volatility in Italian markets to continue.

The remarkable coalition of League with the left-wing populists of the M5S party has ruled for just over a year. The spread between Italian and German ten-year bonds (Bunds) increased by some 30 basis points, while Italian shares fell 2.5% in already depressed markets, led by bank shares.

Elections seem inevitable

Unless Prime Minister Giuseppe Conte resigns immediately, there will be a vote of no-confidence in the Italian parliament this week to officially bring down this government. The initiative will then go to the President of Italy, Sergio Mattarella, who could consult all parties to investigate the possibility of an alternative majority government. When there is no alternative, Mattarella will dissolve the Italian parliament and call for elections within 50 to 70 days, with 13 October mentioned as likely date for new elections. 

Technically, it would be possible for the M5S party to form an alternative majority with the social democrats of Partito Democratico, PD. Both parties would still have a majority in the current parliament, but certainly not in recent polls. The political risks of such a coalition would be very significant for both parties. Especially the M5S party could lose all its anti-establishment credibility, clinging to power by moving from one failed coalition to the other without popular support. 

Salvini seizing opportunities

New elections are therefore likely and probably the reason for Salvini to make his move. His popularity has been growing rapidly and his League party is polling around 38%, much more than the 17% score in last year’s parliamentary elections. Although Salvini has proven to be a formidable campaigner, it is very likely that he would need additional support of one or more right-wing parties in the parliament to form a new majority government and become the next Prime Minister of Italy. 

Markets shaken up

The initial reaction of the bond market to the latest crisis has been to move back towards its trading range of 2018 (between 250 and 350 basis points, or bps, in spread over 10-year German Bunds), although it is not there yet. So far, 2019 had been a good year for Italian assets, with returns on Italian government bonds accumulating to more than 10% in July. The spread with German Bunds fell below 200 bps early summer, as a new budget conflict with the EU was avoided and the ECB announced to buy government bonds again, including Italian bonds.   

The initial spread widening last Friday may have been a knee-jerk reaction to increased political uncertainty, but it may also reflect concern that a government led by Salvini would not be much of an improvement for bond investors. Spreads were already creeping higher in the last few weeks, as with growing tensions in the coalition, the risk of new elections increased. 

Volatility to stay around

Aside from the politics, it is important to note that big fiscal risks were already looming in Italy. We think that economic growth will disappoint the Italian government, while unrealistic costs in the budget will likely make the deficit to overshoot the government’s target by a wide margin. Volatility in Italian bonds will very likely be high again over the next few months, depending on political developments in Italy and their global context, as Brexit, global trade conflicts, tensions in the Middle East and European recession risks are also at play. New Italian elections in 2019 have always been a possibility. 

Fewer Italian bonds in portfolio

In the course of this year, we have seized opportunities to reduce our allocation to Italian bonds to only slightly above benchmark. The duration of the total bond portfolio was recently brought more in line with the (long) duration of Italian bonds in the ETFs we recommend, thus reducing the relative overweight in duration of Italian bonds in the portfolio. 

We prefer to hold on to the slight overweight in Italian bonds in the portfolios for now, if only because this is one of the few ways left to invest in positive yielding bonds. As long as Italian bonds are redeemed in euro, investors will receive their very attractive yields at maturity. 

Similar to what happened in Greece, we very much doubt that Italy really dares to leave the euro and redeem their bonds in their own new currency. This would have a devastating effect on their economy, their banks and the wealth of Italian citizens. A large and stable majority of Italian voters therefore wants to keep the euro. European policy makers also know that Italy’s economy is ‘too big to fail’ and its refinancing needs exceed available rescue funds in the European Stability Mechanism (ESM). As such, the ultimate risk that any Italian government will not redeem its bonds in euros remains very low in our view, keeping us reluctant to go underweight.

Italian risk isolated

Tactical trading of Italian bonds (buy and sell in time) in these volatile markets is a risky investment policy as long as markets are waiting for clarity on the new government and its fiscal agenda. It will probably take a new Italian government, no longer dominated by populist parties, for Italian spreads to return to levels seen before the 2018 elections, at 120 bps.

Italy is turning more and more into a specific and separate risk, joined from the rear by Greece. Spreads on Spanish government bonds were hardly affected, for example, confirming that investors consider them more like semi-core European government bonds. 

Cautious with European financials

From an equity perspective, we are already for some time both underweight in Europe as well as underweight in the sector financials, which is largely linked to Europe's fragile growth dynamics and the region's vulnerable banking sector. The latter issue is strongly linked to Europe's peripheral countries, where banks are still in the process of rebuilding their balance sheets. Obviously, this explains the weak stock market performance of Italian banks being the largest holders of Italian government debt.