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What the Italian election means for your portfolio

05 March 2018

FE Trustnet rounds up the reaction to Italy’s general election and what it might mean for investors’ portfolios.

By Jonathan Jones,

Senior reporter, FE Trustnet

Political risk has come roaring back to the eurozone with euro-sceptic parties performing well in the Italian general election but investors should not be overly concerned, according to several market commentators.

As it stands, Italy is set for a hung parliament following its general election this weekend; although the results are still only partial at this stage.

The anti-establishment Five Star Movement has emerged as the single biggest party, exceeding expectations with more than 30 per cent share of votes cast.

Far right party Northern League received around 17 per cent and former prime minister Silvio Berlusconi's centre-right party Forza Italia getting 13.9 per cent. Matteo Renzi's ruling centre-left Democratic Party is expected to take just 19 per cent.

Latest Italian election poll split

 

Source: HSBC

Overall, Nikki Howes, investment analyst at Heartwood Investment Management, said: “Five Star’s success in securing the largest share of the vote for a single party indicates that populism remains alive in Europe.

“A hung parliament probably maintains the status quo and a coalition led by a centre-right bloc of parties – with a sprinkling of populist forces – appears to be the most likely outcome.”

At the very least the election has avoided a minority populist government, though a fresh election can also not be ruled out, she added.

Below FE Trustnet looks at what the elections mean for the future of the EU but more importantly for your portfolios what the reaction and implications (if any) are likely to be for European bonds and equities.

 

Eurozone

Looking to the politics first, market commentators are split over what the result could mean for the future of the eurozone.

Antoine Lesné, head of EMEA strategy and research for SPDR ETFs, said that political risk has come roaring back and that it will be a blow to the bloc.

“Despite the recent toning down of anti-euro rhetoric, this is a blow to the strong consensus that the common currency has been enjoying of late,” he said.

Elliot Hentov, head of policy and research – official institutions for EMEA at State Street Global Advisors, said: “It is increasingly clear that the eurozone drama is far from over, even if we may be enjoying the current intermission.”


However, Lesné noted that “it may still be too soon to expand into another full-blown eurozone crisis and the market will have to analyse the impact of this election on actual reforms”.

Meanwhile, Adrian Hilton, head of global rates and currency at Columbia Threadneedle Investments said while the election results look “messy”, it is unlikely to bring Italy out of the EU.

“Neither Five Star nor the centre-right (LN/FI) coalition can govern alone, but it seems likely that the future administration will feature one anti-establishment party or another,” he said.

“Such a scenario would probably worsen relations with the European Commission, especially around fiscal targets but we are a long way from Italy ditching the euro: both anti-establishment parties have toned down their euro-scepticism in recent months and surveys continue to show a popular majority in favour of membership of the single currency.”

As such, while there is likely to be uncertainty during the hung parliament, the issues should remain a domestic one.

“Despite that uncertainty, we think euro break-up risk is at its lowest for years,” Hilton added.

 

Bonds

Italy is the fourth largest bond supplier in the world, making up 8.15 per cent of the Citigroup World Government Bond index. This is behind the US, Japan and France and slightly ahead of Germany and the UK.

Weightings of iShares Global Government Bond UCITS ETF

 

Source: iShares BlackRock

As such, the results of the latest election will have a big impact not just on European bonds, but on passive global fixed income products.

David Zahn, head of European fixed income at Franklin Templeton Investments, said there is the potential for yields to rise significantly.

“What is clear is that the more right-wing parties will have greater power and more share of voice in parliament going forward,” he explained. “Importantly, these more right-wing parties are in favour of more fiscal spending.

“With Italy’s debt-to-GDP still quite high, this could be potentially negative for the economy and we could see Italian bonds underperform.”

On Monday morning Italian bonds sold off slightly in reaction to the election news, with the market attempting to price in the new potential make-up of the government.

“We are unlikely to get a clearer picture on how the new parliament will look for many weeks, which means increased uncertainty for Italy in the short term and we could see that reflected as bouts of volatility in Italian bonds over the coming weeks,” Zahn added.

Having reduced the weighting to Italian bonds in the Franklin European Total Return fund, Zahn said he will wait for more political clarity before assessing the position.


Schroders senior European economist Azad Zangana agreed, noting that the biggest risk for investors is “fiscal slippage” which “put Italy on a collision course with the European Commission, and may even awaken the dormant bond vigilantes”.

“A government led by extremist parties could prompt international investors to dump Italian government bonds, causing yields to rise sharply on its huge mountain of government debt worth around as €2.2trn euros or 133 per cent of GDP at the end of 2017,” he said.

“For now, bond buying by the European Central Bank is likely to keep markets calm. However, we do expect quantitative easing to end later this year, making Italy more vulnerable.”

 

Equities

European equities have been growing in popularity among investors over the last 12 months, with the asset class the second-most bought equities region behind the IA Global sector in 2017, according to the Investment Association.

Performance of indices in 2017

 

Source: FE Analytics

While the impact from Italy may shake markets, which have grown less concerned about the politics since Emanuel Macron won the French presidential election in April 2017, it is likely to be short-lived.

Diego Franzin, head of equities at Amundi, said: “In the short term we expect some volatility in the markets, not only the Italian but the European as well, at least until the new government will be formed and it will announce its economic and fiscal program.

“It is difficult to predict the size of the correction. However, the Italian market is the cheapest in the euro area.”

Indeed, compared to the July 2012 euro crisis and December 2016 referendum the discount is smaller with the Italian market trading on a discount of 35 per cent price to book and 15 per cent price to earnings.

“There is a major difference between now and the previous political crisis: this time the economic recovery in Europe and worldwide is much more resilient than in the past and the balance sheet of the companies are much stronger after many years of restructuring programs,” Franzin continued.

“We already had some examples in Europe where a weak political situation didn’t damage too much the economic recovery and after the very first reaction markets tend to be driven by economic fundamentals.

“The long-term drivers will be in any case the capacity of corporates to generate earnings.”

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