Italian political turmoil viewed by asset managers

clock • 11 min read

Political risks are currently causing nervousness in the market – examples include the crisis over the formation of a government in Italy or the conflicts over the US populist trade policy. Relaxation is far from being in sight, because more political events are coming up soon. These include, for example, the parliamentary elections in Mexico and Brazil, the phasing out of the third rescue package for Greece, the US midterm elections in November, and of course the ongoing Brexit negotiations. All of this could be on the nerves of investors, but political developments have often proven that they have an impact on the markets.

The most positive diagnosis of the situation is that Italy has fallen into a state of political paralysis and the question of an eventual Italexit is being raised. A less constructive interpretation is that it is in the middle of a serious constitutional crisis. InvestmentEurope gathered the reactions of industry players on Italy’s latest political developments.

Nicholas Wall, manager of the Old Mutual Strategic Absolute Return Bond Fund, Old Mutual Global Investors
“We believe that there is a very small chance of Italy crashing out of the eurozone, but the risks of a series of unfortunate events leading to an accidental ‘Italexit’ have increased. Notwithstanding the news overnight that Italy looks like it has managed to form a government, the current political situation chimes with Greece in 2015 where the Syriza party won the election promising an end to austerity and questioning the role of the EU. This a useful guide, in our view, as to how the current Italian crisis could pan out. However, there are some big differences between the two countries.

“Our key points are as follows:

“1. The view that underpins everything is that Italy will not leave the euro. It would spell disaster for redenominated Italian household savings, for retail investors who own Italian government bonds (BTPs) and bank debt, for the Italian banks who own BTPs and for the entire European monetary union.

“No Italian government would survive a redenomination – Syriza knew this and eventually backed down, in spite of the fact that Greek depositors had already moved money out of Greek banks. In Italy, deposit levels are much higher with few signs of outflows, yet.

“2. In our view, the current situation in Italy is really about ending austerity and regaining fiscal autonomy from Brussels. This is an easy win for populists who push the ‘we want to give you more cash but unelected bureaucrats won’t let us’ message. Therefore it’s back to collision economics for a while. That said Brussels and Italian politicians know that Italy is constrained by the risk that leaving the euro represents. So it just depends on how close to the brink both sides are prepared to go.

“3. It’s my belief that both sides will be far less reckless than during the Greek crisis. From the European side, Italy is a far greater systemic risk and the contagion potential is much larger. From the Italian side, the situation feels less hopeless (at least among the older generation) than it did for Greece – the Italians have more to lose and they didn’t vote to leave the euro. Therefore if the newly formed Italian government starts to increase its anti-euro rhetoric, some of the electorate may feel misled. We will need to keep an eye on support levels for the government in this scenario.

“4. Italy’s economy is more resilient than Greece’s was.

“5. Much of Europe has lost the religion of austerity that fed populism in core and peripheral economies. This means that, eventually, there is likely be more leeway on the fiscal side. Germany and France, with their recent experiences of populism, should recognise this and acknowledge the political realities – low growth, low earnings and high youth unemployment leads to political change and the EU is a political project. In our view, there is a clear argument for EU authorities accommodating looser fiscal policy. The risk of further economic and political instability rises if Europe doesn’t loosen fiscal policy.”

Paul Brain, head of fixed income at Newton Investment Management
“We remain concerned about the long term implications of rising populism in Europe as it will lead to higher fiscal deficits and therefore more government supply at a time when the ECB is planning to reduce its support for markets.

“That being said recent moves in Italy appear overdone and probably reflect the build-up of positions by investors prior to the elections.

“From here we expect the volatility to continue but the significant yield advantage of other Euro countries could attract demand. The possibility of another election in Italy is a concern as it may allow the populist parties to gain more power. They are unlikely to pull out of the Euro but the increasing lack of fiscal discipline will not go unnoticed by the Northern Europeans. This situation has gained additional significance as the EU moves to debate closer back-stop support for their banking systems.

“For Spain we see little anti-EU risk but are concerned that the political situation leads to uncertainty and perhaps a stale-mate with a lack of government. Sometimes for markets this can be seen as good (budgets are not changed) so we are not expecting further significant widening of Spanish bonds over Germany (assuming Italy doesn’t deteriorate much further).”

Kristina Hooper, Chief Global Market Strategist, Invesco
“I am certainly not attempting to minimize the risks posed by a possible Italexit. However, I do believe there is still the potential for upside and that, at the very least, we are likely to see the ECB help to calm markets. For long-term investors, it is important to keep in mind that geopolitical risk creates short-term volatility in capital markets, but rarely impacts them over the longer term. In this environment, we should be both vigilant and opportunistic — but not scared.”

Chris Payne, managing director at GWM Investment Management
“We are seeing a European-wide sell-off and financials, in particular, have been under pressure on concerns that the next Italian election could turn into a referendum on membership of the euro. Even a weaker Euro and Pound have failed to provide some price stability, as is often the case, and the consensus appears to be that Cottarelli will struggle to gather support to pass a budget, resulting in snap-elections when both anti-establishment parties could return with a larger representation in parliament.

“Italy has the third highest public debt in the world and so this has really spooked the bond markets. The spread between Italy’s 10 year-bund and its German counterpart is now at its highest since September 2013 and we are now seeing a significant reallocation into safe haven assets, driving gold prices and the Japanese yen higher. Italian bond moves are largely isolated but contagion risks are mounting.”

Stephen Jones, chief investment officer at Kames Capital
“Following Macron’s victory, the eurozone was the ‘good news’ story of 2017 as the area’s economy burst into life and global investors returned in droves. This year has seen economic momentum collapse sharply and, perhaps more than coincidentally, populist pressures have brought the fault lines back to the fore. For the moment this is an Italian issue but these pressures exist in most eurozone nations.

“Equity markets have weakened on these changes but Italian worries have largely reinforced a trend already in place. Elevated ratings, and analysts offering a very rosy earnings outlook, left markets vulnerable to poor news and a variety of geo-political developments have emerged to offer that challenge; fat profits were there to be taken.

“These risk markets setbacks have, however, taken the steam out of rising short rate and long yield forecasts and will probably succeed in ensuring that quantitative easing is continued in Europe for longer than might otherwise have been the case. When the dust settles, this should underpin equity markets, allowing progress to be made afresh and from safer levels; the positive earnings outlook offered by analysts have good real-world support.

“However, to be clear, this supposes that Italy stops short of turning a drama into a crisis. Those of us of a certain vintage know well enough that Italian politics are not to be trusted.”

Fabrizio Quirighetti, CIO and co-head of Multi-Asset at SYZ Asset Management
“The recent change in attitude of the Italian populist-extremist coalition towards the euro has triggered the current crisis. Until mid-March, the campaigns and narratives of the Five Star and Lega parties were primarily focused on immigration, and thus had almost no impact on markets.

“Given the magnitude of the jump in Italian government bond yields over the last few days, we can really speak about a crisis. The markets are reacting normally for a crisis, with safe-havens including German bunds, US treasuries, USD, CHF and JPY flying higher, while equities and credit are under pressure, especially if related more or less directly to Italy and Europe.

“As in the situation with Greece a few years ago, it is key for markets and the future Italian government to know if a sufficiently large majority really wants to exit the euro. If not, the anti-EU rhetoric should be more muted and not have such a large impact on markets. If so, it would be fair to expect more trouble for Italian assets.

“In any case, we believe the surge in other peripheral yields such as Spain or Portugal is to some extent overdone. European institutions now have tools such as the European Stability Mechanism and the ECB’s Outright Monetary Transactions to contain the contagion risks from Italy to other countries, as long as these countries “respect and comply” with the euro rules. The political commitment of these countries to the euro and European Union institutions remains strong.

“As far as Spain is concerned, we think the current political uncertainties, not at all related to any anti-euro sentiment, just arrived at a bad time. Yesterday morning, we added marginally to Spain five-year government bonds and Portugal 15-year government bonds in our EUR fixed income funds, where we have very low or little exposure to Italian government bonds, are neutral on Spain and overweight in Portugal.”

La Française
“Tensions on Italian government bond yields have rapidly affected the debt issued by the country’s private sector. Despite the recent progress of the Italian banking sector in terms of solvency and reduction of outstanding bad loans, it is mainly financial sector debt, and in particular subordinated debt, which has been impacted. Finally, the historical link between the financial sector and government debt remains significant, which is understandable.

“The contagion between country risk and the financial sector can be seen at various levels. Firstly, the rating agencies assess the credit quality of a financial institution based in part on country risk. Moody’s has just placed Italy’s rating under negative watch, which could have an impact on the rating of certain financial institutions in the event of a downgrading of the government rating.

“In addition, banks and insurance companies generally hold local public debt, which links them financially to its performance. Thus, UniCredit holds around €51bn in Italian government securities for a CET1 (Common Equity Tier 1) equity base of €47bn. This gives the UniCredit group a capital buffer of €13.9bn compared to the regulatory requirements. In other words, the bank could theoretically suffer a net loss of more than €13bn (i.e. a 27% loss on the €51bn held) without this jeopardising its compliance with the ECB’s regulatory requirements or calling into question coupon payments on Additional Tier 1 CoCo bonds.

“Similarly, at the end of March, Intesa Sanpaolo held €29.9bn in Italian sovereign securities (excluding securities held within its insurance subsidiary), and a capital buffer of €14.6bn in excess of regulatory requirements. The Italian issuers on which we are positioned are therefore sufficiently capitalised to absorb a much larger shock on Italian government debt than that which we have just experienced.

“Today, the capital buffers of the main Italian banks and insurance companies are significant, especially in view of regulatory requirements and previous crises. Indeed, excluding the scenario of a restructuring of Italian public debt, these buffers are largely sufficient to absorb a significant decline in the valuations of the country’s sovereign securities. In addition, the latest results published are reassuring and for several quarters have followed a positive operating trend for banks (disposals of non-performing assets and improved profitability), while Generali continues to improve its solvency margin (211% at the end of March 2018).

“Lastly, a significant portion of this outstanding public debt is recorded as “Held to maturity” in the banks’ portfolios and therefore does not affect their income statement or their equity. The volatility of Italian sovereign securities may therefore weigh on the profitability of the banks, as this has an impact on their financing costs, and therefore on their net interest margin, but this does not currently produce a significant balance sheet effect.”