Italy’s elections have wrenched market attention, Fidelity’s Cooper says

Commenting on the Italian election, Tristan Cooper, Sovereign Debt Analyst at Fidelity Worldwide Investment, warns that Italy’s protest vote against the Eurocrats has wrenched market attention away from the hunt for yield and back onto political risk.

The social disaffection caused by youth unemployment has been strikingly reflected by the surge of the Five Star movement. This can only embolden anti-establishment and euro-sceptic parties in other countries with high and rising unemployment. Such groups have already proven themselves at the ballot box in Greece.

Italian economic fundamentals are fragile and the recession still deep. At best, the political impasse in Italy will push back the market’s expectation of a recovery there. At worst, the contraction could deepen as consumer and business confidence cowers under an extended period of political uncertainty.

European policy makers will be very concerned to avert a potential market meltdown given that Italy is too big to save. The ECB is the only institution really capable of putting out fires. An ECB rate cut next week now looks likely and Draghi will stress that the OMT bond-buying program is there to assist if needed. Yet the OMT is an untested tool that can only be expected to kick in at high levels of market stress. It also requires conditionality, which will be difficult to negotiate with a rudderless Italian state.

The political will to preserve Eurozone stability has been proven in Greece. A new government in Italy, when it is eventually formed, is more likely to be unstable and ineffective than unorthodox and radical. Fiscal discipline is likely to be broadly preserved even if serious structural reforms are now off the agenda. Hence, the negative market reaction to events in Italy may provide an opportunity to buy into the periphery, albeit at significantly higher yields. It will be important to keep an eye on the rating agencies, who could well jangle nerves with another downgrade if policy uncertainty in Italy persists.

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