Market Comment: Turmoil in Italy spooks markets

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Political woes in Italy caused a sharp market reaction in recent days. Although the situation in Italy is a reason for concern, we do not believe another chapter of the euro crisis is unfolding.

Following the veto of Italian President Mattarella on the appointment of eurosceptical Paolo Savona as minister of finance, chances of new elections in Italy have gone up significantly. Financial markets reacted strongly to these developments, as they fear a revival of the discussion about the future of the euro and a potential write-off on Italian bonds. As a result, Italian government bond prices plummeted, with yields on 10-year government bonds – moving inversely to prices – rising above 3%. Equity markets also fell. Bank stocks were among the hardest hit. Finally, the euro further weakened against the US dollar.

Has the euro crisis resurfaced?

There are a several differences compared with the situation in 2011/2012, when the euro crisis sparked fears among investors. We therefore do not expect the current situation to be the next chapter of the euro crisis. First, the Italian economy is clearly benefitting from solid economic growth in Europe and is not in a recession as it was in 2011. Our economists expect the Italian economy to grow by 1.7% in 2018. Second, back in 2011/2012, a larger part of Italian government bonds was owned by foreign investors. In the current situation, Italian bonds are mainly held by the ECB, Italian banks and Italian citizens. Third, the ECB has clearly shown that it will do “whatever it takes” to save the euro. Even though the ECB will be reluctant to step in, it will take action if needed and has the tools to do so.

Nevertheless, we expect that markets will continue to react and for bond yields to be volatile in the near future.The Italian political situation is shaky and we believe that new elections are very likely. The election outcome would be important for the direction of Italian bond prices. Developments in the Italian bond market bear watching, since Italy represents Europe’s third largest bond market. In addition, Italy’s debt levels are already at 130% of GPD. With potential spill-over effects to Spain and Portugal, the European economy could be impacted negatively. It is too early to predict how significant the impact on growth and inflation would be.

What should bond investors do?

Earlier this year, we suggested investors to increase their position in Italian government bonds, as these bonds offered relatively attractive yields. Despite the current turmoil around Italy, we recommend investors to hold on to these positions. We do not believe leaving the euro to be a viable option for Italy. As long as Italian bonds are redeemed in euro, their attractive yields will be realized in the end. We are still convinced that this will be the outcome over the next few years, although Italy has managed to put another serious dent in the reputation and sustainability of the Economic and Monetary Union (EMU). We would not advise to trade Italian bonds under the current volatile and unpredictable circumstances. We prefer to stick to our long-term view, in which both the European single currency and Italian bonds will prevail.

What should equity investors do?

We expect volatility in equity markets to remain elevated until we have more clarity on the impact of Italy’s political woes. European markets will remain particularly sensitive to interest rate behaviour within the eurozone. For the time being, we stick to our slightly positive overall view on equities. We also stick to our regional stance, maintaining a neutral view on developed versus emerging markets; within developed markets, our stance towards both Europe and North America remains neutral as well. At a sector level, we stick to our neutral positioning in financials. Although financial stocks have taken an beating in the past few days, we do not think current price levels represent an interesting buying opportunity.

Conclusion

In the past, we have seen that markets responded sharply to ‘tail risk’ situations (low-probability events that would have an extreme impact if they were to occur). There is a good chance that markets will rebound, but much will depend on how the situation further develops. We will continue to carefully monitor the situation as it unfolds.

ABN AMRO Global Investment Committee
Richard de Groot, Chair

Delen