Italian stocks rebound sharply as political crisis eases

Italy’s leading share index, the FTSE MIB, rallied sharply at the start of the week after comments by the country’s new economy minister helped restore some confidence about Italy’s future in the Eurozone. Italian stocks have taken a hammering since early May when the two anti-establishment parties, the 5-Star Movement and the League, started making progress in forming a coalition government after months of uncertainty following the inconclusive elections in March.

The FTSE MIB plunged by nearly 14% from its 8½-month high of 24,544.26 on May 7 to the 10-month low of 21,122.51 ploughed on May 29 when the fallout from the political crisis reached its height. Fears that the anti-establishment coalition would appoint an anti-euro candidate as the country’s economy minister led to a sharp sell-off in Italian equities and bonds. The situation escalated after Italy’s President rejected his nomination, which opened the prospect of snap elections that could have handed populist parties an even bigger share of the vote. The yield on 10-year Italian sovereign bonds jumped to a 4-year high of 3.39%, pushing the spread between 10-year Italian and German yields to the highest in 5-years, when the Eurozone debt crisis was still brewing.

And it is those concerns about high debt that have come back to haunt the markets as the new coalition government’s program is unnerving investors once again. Italy’s national debt stands at 132% of GDP, the second highest in the Eurozone after Greece. With the new populist government pledging to increase spending and cut taxes, there are fears that Italy may become the next Eurozone member to seek a bailout.

Plans for looser fiscal policy couldn’t come at a worst time as the European Central Bank is preparing for an eventual exit from its bond buying program before the year end and Italian banks are heavily exposed to government debt. Italian government bonds are at risk of being one of the biggest losers from the ECB’s decision to end its asset purchases, as without central bank support, they are less attractive to investors in comparison to safe-haven German bunds. Italian banks, which are already struggling to cope with a high burden of bad loans, could also suffer from the ECB’s stimulus withdrawal as they are large holders of government debt and therefore vulnerable to sharp movements in the price of bonds.

There was relief for traders, however, after Giovanni Tria, Italy’s pro-euro finance and economy minister said in an interview over the weekend that the government was committed to staying in the euro and to reducing the country’s debt level. The FTSE MIB soared on his remarks and Italian yields fell back. But despite the threat of Italy quitting the euro receding sharply, the FTSE MIB is still about 9.5% below its May peak and has erased its year-to-date gains to 1.7%. The 10-year yield also remains elevated, currently around 2.80% compared with around 1.78% before the crisis erupted.

This suggests markets continue to price a substantial risk that the crisis could yet escalate into something bigger. Given Italy’s unstable political landscape, high national debt, sluggish growth rate and indebted banks, it is no wonder investors remain wary about the country’s outlook.

It also explains why banking stocks have been underperforming the wider FTSE All-Share index. The FTSE Italia All-Share Banks index currently stands about 18% below pre-crisis levels with only a modest recovery from its lows.

The sensitivity of stocks to the political situation is evident in the strong negative correlation of the blue-chip FTSE MIB with the 10-year bond yield since the start of the crisis in early May. The FTSE MIB is struggling to break past resistance at 22,400. Further efforts by the new government to calm concerns of increased borrowing and to stay on the path of much-needed reforms could help the index to extend its recovery and head for the next resistance at the 22,850 level.

On the downside, renewed fears about the government’s policies or the health of the banking sector could lead the index to seek support at the 22,000 mark, while a deeper sell-off would bring the 21,600 level into focus before testing the May low of 21,122.51.