Italian moves

by Mawer Investment Management, via The Art of Boring Blog

In cycling, the “move” is the moment when a rider launches the decisive attack of the race. As an example, only two weeks ago, Team Sky leader Chris Froome executed one of the most daring “moves” of the modern cycling era. It happened on the 19^th day of the Giro D’Italia, Italy’s 3-week Grand Tour, on the third and final mountain climb of the day. Froome broke away from the group to solo attack with over 80km still to go. For those unfamiliar with cycling, this was simply one of the most impressive physical feats ever witnessed in the sport.

Moves exist in markets, too. These are non-standard events that disrupt market rhythm. As an example, the September 15, 2008 Lehman Brothers bankruptcy filing was a move: it meaningfully disrupted markets and had consequences that reverberated globally. These types of moves in markets are often events where prices move discretely and sharply. Like in cycling, it can be difficult to know in the moment whether a move is the move.

And that brings us to Italy. Italy has been the source of drama in recent weeks, and it hasn’t all been about men racing bicycles in spandex. A political stalemate has been present in the country since March and lately it’s been making investors nervous. Last week, government bond yields spiked—the 2-year bond yields jumped 1.80%—and then fell back again as a government finally formed. The episode not only highlighted some of the risks presented by Italy’s political situation, but also showcased how difficult it can be to know what the moves will be.

Jitters around populism

Italy’s political situation has been tenuous since 2016’s constitutional referendum. While this year’s March election was intended to clarify the situation, it instead resulted in stalemate. No party won enough seats to form a government and that left politicians scrambling to form a coalition.

One of the challenges in forming this coalition government has been ideology. The two parties that surged in the election—the Five Star Movement and the League—have populist platforms. Some establishment politicians have shuddered at the prospect of their policies being enacted. Another challenge has been the resurgence of Silvio Berlusconi. Recently, an Italian court ruled that the three-time prime minister could run for office again.

Tensions reached a boiling point last week, just as a coalition was about to coalesce. In a situation like this, the President holds powers to approve cabinet members. To the surprise of many, President Mattarella refused to accept the nomination of Paolo Savona, the preferred candidate for finance minister put forth by the Five Star Movement and the League. Mattarella saw Savona’s Euroscepticism as a potential threat to foreign investor confidence. But in denying Savona, Mattarella prompted outrage from the anti-establishment parties, leading many to worry that a snap election would ensue. This caused mild panic in financial markets that a future election would morph into a referendum on Italy’s place in the EU and the monetary union.

The result was that Italian bond yields spiked. For example, 2-year Italian bonds rose from 0.80% to 2.65%, a large jump for the short end of the yield curve. Investors seemed fearful about Italy’s future. This occurred in tandem with the ECB reducing its purchases of Italian bonds.

Thankfully, by the end of the week there was some resolution. Despite earlier threats of an election, a coalition government was formed and sworn in on Friday, with law professor Giuseppe Conte becoming the new prime minister. Markets and politicians seemed appeased. A three-month hiatus finally ended and a larger crisis was—at least temporarily—averted.

Not yet the move, still a risk

This recent political episode has two investment lessons worthy of paying attention to. First, Italy’s political situation is a risk for markets. Second, it highlights how challenging it can be to ex-ante call a move.

Why do investors worry about Italy? Because the consequences of Italy actually leaving the monetary union would be significant. Italy is deeply tied into the Eurozone, while also having a large bond market. A shift away from the euro currency would be highly disruptive and would likely come with a financial crisis. Contagion could easily spread to the rest of Europe, and to markets in the rest of the world.

For now, it seems more likely that Italy remains in the monetary union. As BCA pointed out in their research note on May 30, support for the Euro Area is in the high 50% range. Substantiating that viewpoint, the anti-establishment parties have toned down much of their strongest rhetoric. However, a schism is also not a non-zero probability. At least 40% of Italians seem to be Eurosceptic and populism is on the rise.

In addition, Italy highlights how difficult it can be to know if a move will really morph into something disruptive. In cycling, we don’t always know what moves will stick—the same can be said of markets. Last week, politicians eventually formed a government and the spike in yields settled. But it doesn’t always work out this way; sometimes what we believe to be irrational courses of action do prevail.

For the investor concerned about Italy, it’s worthwhile to remember the basics: market “moves” are best protected against via portfolios that are constructed to be resilient. Investors with sensible long-term strategies probably don’t need to worry about Italy. Specific to our firm, our clients have minimal direct exposure to domestic Italian affairs.

With that said, the recent Italian drama has been both insightful and absorbing to watch—both on and off the bike.

This post was originally published at Mawer Investment Management