Italy and Germany don’t scare the markets

Market analysis - 3/1/2018

The markets are guilty of overconfidence in a supportive economic environment and seem to be paying little heed to political risk in Italy and Germany.

The spread between ten-year Italian bonds and their German counterparts has narrowed by 30 basis points year-to-date. We feel that caution is necessary in the lead-up to Italian elections and the vote by SPD members on whether to participate in a broad coalition. 

Although political risk remains contained in Italy in the short term, no scenario can be completely ruled out. Investors are betting either on a right-extreme right coalition that would not apply the costly measures contained in its programme, which are incompatible with Italy’s finances, or on a broad coalition agreement between pro-European parties. But this scenario hangs by a thread in seat projections, while Italy’s electoral system, characterised by a mix of proportional representation and a first-past-the-post election, makes the outcome unpredictable. In these conditions, we are underweighting Italian sovereign debt. 

A second crucial political event could destabilise the markets. Since 20 February and until 2 March, SPD members have been asked to vote on the coalition agreement negotiated with Angela Merkel’s CDU/CSU, already approved near unanimously by the 1,000 delegates of the German chancellor’s party on Monday 26 February, but only 56% approved by SPD delegates. The result will be known on 4 March. A vote in favour would pave the way to the formation of a government. If the vote goes the other way, German political instability would imperil plans for closer integration of the eurozone shared by the SPD and President Macron, probably weakening the performance of peripheral sovereign debt. 

The combination of these two crucial political events could create volatility, a source of opportunities that needs to be seized at the right moment. As such, we are holding onto liquidity to give us leeway to make new investments.

François Raynaud, Asset Allocation and Sovereign Debt Manager at Edmond de Rothschild Asset Management