Markets reacted sharply to the weekend’s news that ongoing attempts to form a coalition government in Italy had collapsed after the President’s rejection of the proposed Finance Minister, prompting likely new elections later this year.
Unstable governments in Italy are nothing new, but markets are worried this time because they now raise the threat of an effective anti-EU campaign taking hold.
The market response was telling. Italian two-year government bonds, which had a negative yield only a few weeks ago moved up to nearly 2.5%, far above other EU counterparts.
The Italian equity market, from being one of the better performing global indices this year in early May is now flat, with double digit drawdowns at an index level and in banks in particular.
Why are moves so large? We’ve certainly had political uncertainty elsewhere: Germany only completed its own government building process in March, while Spain faced the Catalan independence referendum in October last year and has its own confidence vote in the Prime Minister this Friday. However, moves there have been far less extreme.
The challenge for investors in the Italian case is due to the specific nature with relatively binary scenarios, which change the very risk properties of assets. I blogged about binary and conditional risk dynamics in the context of emerging markets last week, but in the European context we are dealing with something quite specific.
The peripheral European economies are still reliant upon support from the ECB but that support is conditional in nature; countries must play by the rules (most importantly with regards to fiscal policy and structural reform) to be eligible.
When that support is in place, it plays a similar role to a lender of last resort, but when it is removed, countries without the ability to print their own currency become beholden to their own ability to pay off their huge debt levels.
What was previously rate risk, can very quickly become more like credit risk
This was very much how markets treated Portugal in early 2016, when their proposed budget appeared to conflict with EU rules.
Both these examples will be very much in investors’ minds in trying to assess developments in Italy. The emotional responses engendered by our experiences of those events will also be playing a huge role, no matter how much we try to stay objective. We can now very easily picture extreme scenarios: Italian default? Italian exit from the EU? No matter how little has really changed over the weekend, simply reintroducing these risks to our psychological probability distributions can spark huge reactions in markets.
From our perspective, it seems we are beginning to see some very episodic behaviour here: price action is rapid and frightening, a single story is dominating the narrative, and we are now beginning to see contagion in other assets.
Will this mean an opportunity for investors, as was the case in Portugal in 2016, or some very real pain, as in Greece? The situation can always get worse, but it cannot be denied that we are now getting better compensation for these risks than we were a week ago.