Italy is special as only a very small percentage of its €2.7 trillion government debt market is held abroad. More than two-thirds is owned by Italian residents, i.e. banks, pension funds and insurance companies. They tend to be less sensitive to price variations. And the ECB holds 15% of Italy’s debt.
After a long period of indulgence, markets have finally woken up to the threats posed by European political upheavals. Assessing the risk premium is, however, still tricky. Buoyed by a favourable economic environment, markets had been overconfident and Italian 10-year spreads actually tightened against German Bunds between January and the Italian elections in March.
Italy's President, Sergio Matterella, vetoed the cabinet proposed by the M5S/Lega coalition’s choice of Prime Minister, Giuseppe Conte, and has now asked Carlo Cottarelli, who used to work for the IMF and is a fiscal affairs specialist, to form what will probably be a caretaker government ahead of elections to be held in the coming weeks or months. Investors will be closely watching what happens next and especially the election campaign which could well feature even more anti-European rhetoric than the previous campaign. There is a possibility that all the parties in the running might harden their stance, but markets will no doubt reason that leaving the eurozone would be much more complicated than withdrawing from the European Union.
An extended period of political uncertainty in Italy will almost certainly fuel market volatility but also create opportunities. That is why we have kept cash so as to be able to seize any buying opportunities. Eurozone peripheral countries are still attractive but only if we remain highly selective. Portugal, Greece and Cyprus, for example, are interesting as they stand to benefit from improving economic momentum and reduced political risk.
By François Raynaud, Asset Allocation & Sovereign Debt analyst at Edmond de Rothschild Asset Management