Market sentiment has shifted to risk-off

Italy’s proposed coalition collapsed over the weekend after the president refused to accept eurosceptic Paolo Savona as Minister of Finance. Markets have since reacted, with Italian government bond yields rising above their eurozone counterparts. Unsurprisingly, with the possibility of another election in the cards, market sentiment has shifted to risk-off in light of the political uncertainty.

Three questions for Italy going forward

Against the backdrop of the latest polling data, it is really hard to predict what will happen next in the political arena. The latest poll of polls shows how Lega (League) has gained popularity at the expense of Forza Italia, and that the 5-Star Movement (M5S) has lost some momentum lately. This makes it hard to predict what both Lega and M5S really want at this juncture:

• Does Lega want to capitalize on their improvement or do they want to hold out in the hopes of being able to challenge M5S for the top spot?
• Does M5S really want new elections, given they would have to change every candidate (or change their bylaws)?
• And finally, what will the official return of Silvio Berlusconi mean now that he is again allowed to run for office?

We don’t have answers to these questions. Only time will tell.

Looking over the longer term—What could happen next?

What happens over the next year or two will determine not only what Italy’s relationship with the eurozone and its institutions will be, but it will also determine whether or not current market pricing provides investors with a potential opportunity.

With this in mind, we’ve are keeping a close eye on the following topics:

Eurozone membership

We continue to believe that risk to Italy’s membership in the eurozone is limited. The euro still has the support of roughly 60% of Italians, and both Lega and M5S have noticeably toned down their euro-skepticism. Even more, President Sergio Mattarella is clearly trying to protect Italy against anti-euro moves.

Governance

Whether it happens now or after elections in July or August, most roads lead to a coalition government of M5S and Lega. Of course, this can change quickly given how volatile Italian politics is, and we believe that neither the Democratic Party (PD) or Forza Italia should be discounted. However, for now we are focusing on what a coalition with Lega and M5S could actually get done as opposed to what they want they do. We continue to believe that the constraints imposed by both President Mattarella and financial markets will force a new government to tone down its fiscal plans significantly.

The European Central Bank (ECB)

The ECB might have an important role to play, but only if things worsen significantly from here. At that point, it will have to assess the situation and determine whether the risk to the eurozone is such that it needs to provide support—or whether it needs to teach Italy a lesson. Given Italy’s importance and size, we suspect it will choose the former and provide support to specific banks using Emergency Liquidity Assistance (ELA). Or, it may be via the financial system in general through new LTROs (long-term refinancing options) and an extended quantitative easing program. However, we only expect this to happen if Italy slides into a crisis that threatens the eurozone’s overall recovery.

Banks

We believe that the risk of a doom-loop (i.e., where increased sovereign risk weighs on the banking sector and starts a vicious downward cycle) is real but not as large as many fear. Italian banks are, by and large, quite well capitalized, and it would take a very big decline in government bond prices before they would be at risk of insolvency.

What’s in the cards for financial markets?

Italian bonds

From a valuation and sentiment perspective, Italian bonds are now considered cheap and oversold. On the other side of the equation, German Bunds are now overbought and expensive. Italian equities have only recently pushed into oversold territory and are not yet considered particularly cheap. The Italian yield curve has flattened dramatically over the past few days and weeks, which shows that the market is particularly worried about the next two years (see chart below).

The euro

The euro at 1.15 vs. the U.S. dollar (via the U.S. Dollar Index, as of May 31, 2018) is interesting because that has previously proven to be a strong support level. The euro is already considered cheap and at these levels is certainly oversold. However, the cycle risks we see are keeping us from pulling the trigger for now as we await more clarity out of Italy.

Uncertainty? Look at value, sentiment and the political risks  

The uncertainty surrounding the political developments in Italy is such that, at Russell Investments, we have to operate in an environment best described as hazy, foggy and muddy. In circumstances such as these, we utilize a two-step approach in our investment process.First, we look at the guidance from our price-sensitive building blocks: value and sentiment. Those are currently telling us that Italian assets are cheap and oversold. Second, we look at the political risks that are weighing on our cycle building block. I.e., are those risks growing or lessening—and what are the different scenarios we can envision?

Currently, we think the political risks are growing, incrementally pushing our cycle score deeper into negative territory. Combined, our building blocks have triggered a move from an underweight position to neutral for Italian government bonds, but are not yet telling us it’s time to move to an overweight.