A few surprises, but wait-and-see dominates for now
The inconclusive results of the elections in Italy on 4 March have left many investors perplexed about the future of Italian politics and hence the outlook for Italian assets.
Given the high level of government debt in Italy, proposed political party policies that would significantly cut tax revenues (such as a flat tax) or increase expenditure (such as a guaranteed minimum income) might seem to some as gambling with the country’s future. Incidentally, in Italian, “Che casino!” also means “What a mess!”
The elections produced a few surprises. The results at the time of writing suggest a hung parliament as opposed to the centre-right majority that we had expected.
- The Lega (League) party headed by Matteo Salvini took a greater share of the vote than Silvio Berlusconi’s Forza Italia, putting Salvini in a position to potentially lead the next government.
- The share of Matteo Renzi’s Partito Democratico was lower than the polls had indicated, calling into question his position as head of the social democrats.
- Finally, the Movimento 5 Stelle (Five Star Movement) received the highest share of votes of any single party, highlighting the disaffection of voters with traditional political parties in Italy.
Muted market reaction: hope rather than concern?
The markets’ reaction so far, however, has been muted. The spread of Italian 10-year government bonds over comparable German paper is up by less than 10bp, as of mid-afternoon on 5 March.
This mild reaction likely reflects the assessment of investors that the eventual outcome of coalition negotiations will still be a centre-right government.
- We expect Italian President Sergio Mattarella to first ask the centre-right to form a government, though this is likely to kick off a long period of negotiations.
- We do not, however, expect an agreement between the Lega and Cinque Stelle parties, given their diverse constituencies, nor one between PD and Cinque Stelle, as PD will first need to assess its own leadership and electoral prospects.
If a centre-right led government turns out to be unachievable, a technocrat government could be put in place (again). This would probably not be stable and could well lead to new elections in the coming months.
Some support for BTPs from yields…
Our fixed-income team is neutral on Italian government bonds (BTPs), reflecting both positive and negative factors. In the short term, there is still strong demand for BTPs, principally from domestic Italian investors who are largely underweight the asset class. Two-percent government bond yields in Europe are still a relative rarity. On the other hand, an extended period of political instability is clearly negative for BTP yields. It is overweight, however, other ‘peripheral’ eurozone government debt markets.
Italian equity markets have reacted more negatively, with the FTSE MIB index falling compared to gains for most other markets in Europe. This is in contrast to the pattern since last year, which has seen Italian equities generally outperform European markets.
Our multi-asset team has gradually added risk exposure to eurozone equities since the beginning of the year. The rationale is that they see earnings growth beating consensus estimates for 2018, while valuations are attractive, especially relative to the US market.
Last week, however, in the face of the perceived political risks in Germany and Italy, they decided to hedge part of their exposure via equity options and BTP shorts and by reducing their exposure. Their view was that markets had been quite complacent about the Italian election and outcomes that might be market-unfriendly such as ‘no-coalition and new elections’ scenario.
The hedges have worked well so far and the team is assessing whether to extend them given the election results.
…and for equities from valuations and the economic recovery in Italy
The outperformance of Italian equities versus European equities over the last year was in fact not the result of better economic data in Italy. While the country has benefited from the global economic upswing, it has nonetheless lagged other countries in Europe. For example, last week, Italy’s purchasing managers index disappointed market expectations, coming out at 56.8 compared to expectations of 58.0. GDP is forecast to rise by just 1.5% in 2018 versus 2.5% for the eurozone.
The driver of the outperformance has primarily been cheap valuations compared to Europe. At the end of last year, the forward price-to-earnings (P/E) ratio for the market was 16% below the average since 1987, while for Europe, the multiple was 5% higher. Even with the outperformance of the market over the last 12 months, over the medium term, it still offers compelling valuations, in our view.
Italy is likely to go through an extended period of political uncertainty, reflecting the split election results. Fortunately, the economic recovery remains in place, even if the pace does not match that in the rest of Europe. This should benefit Italian equities more than it will bonds as worries about government finances and the country’s relationship with the EU weigh on fixed-income investor sentiment.