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Basking in Sun, Italian Markets May Face a Bleaker Autumn

Updated on
  • Italian stock index outpaces peers to hit December 2015 high
  • Default-swaps, bond spreads decline but political risk looms

The European heatwave known as Lucifer might as well be warming financial markets, judging by the recent performance of Italian assets.

The benchmark stock index climbed to a 20-month high, the risk premium on Italy’s government bonds has tumbled and the cost of insuring that debt is near the lowest in a year. But the best advice for investors may be to enjoy it while they can: the devil could really be in the nation’s impending risks.

The quickening growth and solid corporate earnings that have propelled the rally face a series of stern tests in the coming months, not least a looming general election in which populist, anti-euro parties may play a key role. The country is also one of the most exposed to a shift in monetary policy from the European Central Bank, which has bought almost 284 billion euros ($335 billion) of Italian debt under its latest asset-purchase program.

“Enjoy a quiet August ahead of September’s challenges,” UniCredit SpA Deputy Head of Fixed-Income Strategy Luca Cazzulani and Chief Italian Economist Loredana Federico wrote in a note last week. “What could go wrong in the coming weeks? Not much, really. The usual culprits are poor economic data at the domestic level, politics, a step up in expectations of policy tightening and a sudden shock in global financial markets,” all of which have only an outside chance, they said.

In the current window, the good news has stacked up for Italy. The nation’s Services Purchasing Managers’ Index reached a 10-year high on Aug. 3, supporting the view growth is catching up with the rest of Europe. The International Monetary Fund has upgraded its forecast for the country’s expansion to 1.3 percent, which would be the fastest in seven years.

Market Momentum

All of which has been fuel for the markets. The FTSE MIB Index has gained about a third in the past 12 months, making it one of the best-performing western European markets.

Meanwhile, Italian government bonds are also rallying after the prospect of an early election faded, and Paolo Gentiloni’s government took steps in fixing the banking system and its soured loans. The spread between 10-year Italian bond yields and those of Germany is trading at the lowest in 2017 having narrowed to 152 basis points from this year’s high of 213 basis points in April.

Also boosting stocks and debt: Italian companies are posting the biggest earnings beats in the second quarter in Europe after the Netherlands, according to a note from UBS Group AG on Aug. 4. As the likes of UniCredit and Intesa Sanpaolo SpA, the country’s largest banks, reported results that exceeded analyst expectations, the equity index for banks soared. It’s up more than 80 percent since hitting a four-year low in July last year.

And, although the samples are small, Italy’s companies have posted the largest median decline in credit-default spreads in the iTraxx Europe CDS Index so far in the third quarter. The cost to insure Italian sovereign debt against default for five years is at the lowest in almost a year.

Gathering Clouds

Yet by September the market could be facing headwinds. The ECB may signal the beginning of the end of its quantitative-easing program that month, which would remove a key buyer of Italian bonds. The country has the second-highest debt-to-GDP ratio in the euro zone at more than 130 percent, and yields on its debt jumped in late June when ECB President Mario Draghi made comments at a forum in Sintra, Portugal which investors construed as hawkish.

“Bond investors have shown that reduction of policy stimulus is a nerve,” Cazzulani and Federico wrote in UniCredit’s note. “Pressure on yields would materialize as soon as the hawks become more vocal, driving euro-zone yield curves steeper. Furthermore, the reaction of the BTP-Bund spread to the speech in Sintra suggests that investors still regard tapering as negative for Italy.”

Meanwhile, regional elections are due in Sicily in November. Should the populist Five Star Movement come first, it would dramatically up the stakes for the general election that must take place before the middle of next year. Five Star has called for a referendum on Italy’s membership in the euro.

— With assistance by Heather Burke, Blaise Robinson, and Stephen Spratt

(Updates pricing and charts throughout.)
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