The Italian president’s decision to reject the formation of an anti-EU coalition government has set the stage for further geopolitical risk and more market uncertainty for the summer months, fund managers have warned.
Markets across the globe sold-off heavily yesterday after Italian president Sergio Mattarella refused to accept the nomination of eurosceptic Paolo Savona for the role of finance minister. Savona was put forward for the role by the Five Star Movement (M5S) and the League, which had been attempting to form a government since the country’s elections in March.
However, Mattarella argued that the installation of Savona as finance minister would have threatened investor confidence in Italy and put the economy at risk of destabilisation. Savona is a longstanding critic of the EU and called the euro “a German cage” in his latest book 'Like a Nightmare and a Dream'.
Giuseppe Conte, M5S and the League’s choice to serve as prime minister, resigned after Mattarella's move while the president later installed former IMF economist Carlo Cottarelli as interim prime minister and asked him to form a government. The country will have fresh elections in the autumn.
Performance of index over 2018 to date
Source: FE Analytics
Jake Robbins, senior investment manager on the Premier Global Alpha Growth fund, said the rejection of a democratically elected coalition government has put Italy into a “constitutional crisis”. This has been exacerbated by the fact that the coalition holds anti-EU beliefs.
“In echoes of the euro crisis earlier this decade, these events could ultimately threaten the future of the EU, or at the very least, question it in its current form,” he added.
“Whilst it is no surprise that Italian yields have soared and equities plunged as investors reprice the actual risk of holding Italian assets, this crisis has been on the cards for some time and shows how complacent financial markets have become in the era of quantitative easing.”
Robbins, who has 19.9 per cent of his portfolio in continental European equities, said that investors also need to be aware that there has been a noticeable slowdown in growth across the EU in 2018, which will further weigh down sentiment towards Italy and Europe.
When these concerns are added to heightened geopolitical risks in other parts of the world, rising interest rates and the reduction in central bank support through quantitative easing, the outlook for financial markets is “far less certain than over the past few years”, according to the manager.
But this does not mean he has turned bearish, saying: “In this environment, volatility can create some excellent investment opportunities as many assets inevitably get mispriced in distressed markets.
“Whilst Italian businesses tied into the local economy, such as banks, look particularly vulnerable, given wider uncertainty across the EU (let’s also not forget Brexit), then financials, real estate and domestic cyclicals, such as retailers, across the entire continent may find the going tough for a while. But for the brave, those high-quality businesses with global franchises that can continue to benefit from strong global growth could present good opportunities to invest during the turmoil.”
10-year Italian/German government bond spread
Source: Bloomberg
Chris Payne, managing director at GWM Investment Management, said that the sell-off in risk assets reflects investor concerns that the next Italian election could turn into a referendum on membership of the euro.
Many critics believe that interim prime minister Cottarelli will struggle to gather support to pass a budget, which would increase the likelihood of snap elections. This in turn would run the risk that anti-establishment parties M5S and the League could increase their representation in parliament, adding to market uncertainty.
“Italy has the third highest public debt in the world and so this has really spooked the bond markets,” Payne added.
“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.”
Italian 10-year bond yields jumped 3.38 per cent to their highest level since March 2014, while the spread over the German bonds widened 2.5 per cent in reflection of how concerned bond markets are about Italy’s future.
Fiona Cincotta, senior market analyst at City Index, said the political drama in Italy has reawakened fears about eurozone stability and default risk that had fallen off the radar for a number of years.
“The Italian president frustrating efforts by the two eurosceptic populist parties to form a coalition government means that the status quo prevails in Italy for now,” he said.
“But far from calming the markets, risk off is being fuelled by the expectation that there will be another election sooner rather than later and that the populists will have a stronger hand, posing greater potential risks to the euro and resulting in a more extreme market response.
“Whilst the chances of Italy actually defaulting on its debt is, in reality, still a long way off, we are certainly looking ahead to a summer of political unrest in Italy and volatility in the markets.”