Downside risk to asset pricing is now in play in Italy, Lombard Odier warns

The message from the Italian election results is crystal clear: Europe’s third largest economy has become significantly polarized, which has led to a surge in support for extreme elements and extensively damaged mainstream parties in this round of political change in Italy, warned Salman Ahmed, Fixed Income Strategist at Lombard Odier Investment Managers.

A grand coalition is clearly a possibility over the next few weeks.

However, according to the strategist, it will certainly be a challenge to make it work for a sustained period of time and any meaningful progress on reforms is likely to be quite limited.

“The next possible scenario is further elections in few months’ time. The backdrop of a surge in political support for parties with extreme agendas and outlooks is likely to play a big role in shaping expectations for the results,” he said.

Meanwhile, any potential ECB help or perceived lack of it in the short term is likely to become a key factor in driving market action.

“We think periphery bond markets will have to sell-off considerably from current levels to bring ECB in play: without market pressure the OMT (“Outright Monetary Transactions”) is likely to remain dormant. A pro-active response from the ECB remains an option, but we think that it is a tail-scenario at this stage rather a central one,” Ahmed said.

Given the uncertainty created by the hung parliament result and the strong rally strong downside risk to risky asset pricing is currently in play.

“Our global factor analysis shows that EMEA countries remain the most vulnerable in the Emerging Markets space, with European equities and credit the most vulnerable in the Developed Markets space. Furthermore, we would expect another rush for “safety”, as the uncertainty around Italy plays out in coming days and weeks,” Lombard Odier said.

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