The political upheaval in Italy has raised a number of fears, not least that Europe’s fourth-largest economy may want to withdraw from the EU, if not subvert the euro with a parallel currency too. We view both events as unlikely, but the mere prospect of them occurring – amid continuing political uncertainty – caused cascading market reactions: yields on Italian debt soared as prices plummeted; a selloff in Italian equity markets spilled over to the US; and the euro fell to its lowest level against the US dollar this year. At the climax of the recent crisis, markets were pricing in a high probability of default on Italian debt, with no possibility of outright monetary transactions (OMT) by the ECB. The subsequent re-steepening of the yield curve is a welcome sign of normalisation.

Two possibilities: elections in September or a new political government

The political environment in Italy is fast-changing. Since parliamentary elections in March, which resulted in a hung parliament with no party or coalition winning a majority of seats, Italy hasn’t had a government. On 27 May, President Sergio Mattarella rejected the nomination of an economics minister whom he considered anti-EU and anti-euro. This triggered the latest surge of market volatility globally and raised the spectre of his impeachment.

From our perspective, Italy’s political situation boils down to two possibilities – both of which are likely to create a degree of certainty that may buoy financial markets in the short term:

• The first is the formation of a caretaker government, led by interim Prime Minister Carlo Cottarelli, followed by a new round of elections that would effectively be a referendum on Italy’s role in the EU. We believe that September is a more likely date for these elections.
• The second possible scenario is the formation of a new political government, possibly with the Five Star Movement and the League party; or a centre-right government led by the League (albeit an unlikely outcome without a snap election).

If new elections are held, a populist outcome could be more hostile to the EU’s leadership. Then again, recent events could trigger an earnest dialogue with the EU, which would not want Italy to leave the union. Until then, we expect that the EU will be in a mostly wait-and-see mode, and that it will not interfere with Italy’s affairs.

Economic and market outlook: headwinds persist

Even before recent events in Italy, the global markets were facing a few headwinds:

• The first is that leading economic indicators may be “rolling over” as the global economy moves into a late-cycle stage of growth. We don’t anticipate this will result in a hard landing for the world’s major economies, let alone recession, but less cyclical momentum implies less momentum for risky assets.
• The second is a general sense of political uncertainty. This is an issue that we believe will persist on a global scale for some time, considering that the underlying reasons for populism’s rise are not going away: growing inequality, threats from automation and an anti-globalisation mood – as already exemplified by Brexit.

What’s surprising is that Italy’s voters have recently been voting for anti-establishment parties even though the country’s economy has been doing better. The euro is less popular in Italy than it was a few years ago, which has unnerved politicians throughout the EU. Yet we believe this mood would change before elections are held: given the market pressure that is severely hurting Italian assets, we suspect that Italian voters would think twice before voting against the euro.

Investment implications: a summer of uncertainty

We were already cautious on Italian government debt, and recent events have not changed our stance. We expect continued volatility over the summer, particularly given that the European Central Bank is set to begin withdrawing quantitative easing. The ensuing rise in interest rates would be a key issue for the affordability of Italian debt, and it could have global implications given that Italy is the third-largest borrower in the world.

Italian equities were generally doing well before recent events as the country’s economic cycle improved and earnings growth looked positive. But Europe seems to be a centre of uncertainty for global investors, as recent troubles in Spain have added to those in Italy. The selloff of euro-zone banks seen in recent days has been driven by systemic fears, the banks’ holdings of Italian sovereign debt and a lack of interest-rate rises as the ECB ends quantitative easing (QE) later this year. We believe these fears are exaggerated, yet we expect investors to stay cautious on European equities – particularly given the potential for a summer of negative news headlines.

Globally, monetary policy will continue normalising, but central banks will watch carefully for any signs of contagion in their economies. Italy’s crisis could also encourage the US Federal Reserve to raise rates more quickly. As liquidity provided by central banks is pulled back, it does not necessarily imply that markets will fall, but we believe it may become more difficult for markets to move much higher. Investors should brace for additional market volatility, particularly given the potential for cyclical economic data to weaken.

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