Focus on fundamentals in face of uncertainty

Italy’s populist M5S and Lega parties eventually formed a coalition government last week, but the twists and turns in the negotiations sent risk assets on a rollercoaster ride.

On 29 May, Italian two-year government bond yields surged by 184bps, the largest one-day move in G7 two-year bonds since US yields jumped 146bps in October 1982. The risk-off reaction spilled over into other markets, with Italian, Eurozone, and US equities all falling, the euro depreciating, and safe-haven US Treasury bond prices rallying. 

Markets have recovered their poise. Italian equities have recouped last week’s losses, and two-year yields are 200bps lower than last week's peak. But the sharp reaction confirms our view that volatility has returned. Focus will likely now shift to the coalition’s policy agenda, and uncertainty is likely to persist. We take stock of the most affected assets – Italian government bonds, euro high yield, and the euro itself. 

The sell-off in Italian government bonds appeared overdone.

• Italy runs a primary surplus of 1.9% of GDP, and even after interest payments is able to modestly reduce its debt burden each year. Over the next 18 months only 16% of government debt needs to be rolled over. And the average-weighted cost of new funding is currently around 2%, lower than average coupons of maturing bonds over this period of around 3%: the country saves interest costs as it refinances. While the new government’s fiscal policies will bear monitoring, after lengthy negotiations, the president has ensured a technocrat will be finance minister. The disproportionate move in two year yields compared with an expected default risk of less than 2% suggests this area of the yield curve could be the most attractive. 

European high yield (HY) may now underperform.

• Italian corporate bonds have been relatively resilient in the recent sell-off, partly reflecting a perception of lower redenomination risks, and the ECB's ongoing purchases. Yields on the majority of Italian corporate bonds rose last week less than those of government bonds of equivalent duration, which is likely not sustainable. Given Italian issuers represent about 17% of euro high yield indexes, but only 5% of the euro investment grade market, as the dust settles euro high yield may underperform. 

There may be a better entry point to buy the euro.

• We have a positive longer-term view on the euro, targeting EURUSD 1.30 over 12 months. But four conditions need to be met before EURUSD can resume a stable appreciation path: first, greater political clarity in Italy; second, more robust economic data; third, the European Central Bank needs to confirm its intention to unwind its quantitative easing program; finally, it is important that US bond yields stay within recent ranges. We expect these conditions to be met over the balance of the year: leaders of both the M5S and Lega parties have confirmed their intention to remain in the euro, solid global growth should support Eurozone exports, and higher Eurozone inflation in May should help bolster policymakers’ confidence. For the moment we see better FX strategy opportunities in going long JPY or CAD versus the USD, or buying the NOK versus the EUR. 

Overall, we see the risk of wider contagion from Italian political uncertainty as relatively limited, and keep a positive stance on global equities amid good global growth.

But the rise in volatility demonstrates the importance of diversifying portfolios across a range of economies, limiting exposure to risky credits, and building in downside protection and counter-cyclical positions.

Bottom line

Political uncertainty in Italy caused a risk-off spasm in Italian and global markets last week. A new populist coalition government has now been formed and markets have recovered, but policy uncertainty remains and volatility is likely to persist. In our view, the sell-off in Italian government bonds appeared overdone; European HY may now underperform, but it is still too early to buy the euro. 

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