February 26, 2013 12:03 pm

Election jolt fractures fragile sentiment

Italy has spoiled the party; risk aversion is back in fashion.

After Monday night’s inconclusive election result, a sharp US sell-off in late trading spread across Asia and into Europe, sending equities tumbling and bond yields sharply higher in the crisis-hit eurozone periphery.

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What happens next will depend on whether investors consider Italy’s election merely a correction, or changing fundamentally the story that has rallied markets since late last year – namely, decisive central bank action has created the conditions for a eurozone healing and gradual recovery in the world economy.

“I can’t help thinking that this is a contender for being the most hazardous election result yet in the history of the eurozone,” says Julian Callow, chief international economist at Barclays. “The result shows the Italian electorate to be fractured, and if you multiply this message by the size of Italy’s debt, it gets serious.”

After gyrating wildly this week, the FTSE MIB index ended down 4.9 per cent yesterday. Italian borrowing costs also surged, with the yield on 10-year bonds – which moves inversely to prices – rising more than 40 basis points to more than 4.9 per cent at one point before edging down slightly. A 10-year bond auction today will be watched closely.

As 10-year yields head towards 5 per cent, domestic buyers could re-enter, says Steven Major, head of fixed income research at HSBC. “There is nowhere else for them to go – no other sovereign bond market offers such liquidity and [high] yields. I’m broadly constructive – we are not in a panic situation.” Italy has a long tradition of shortlived governments. But Mr Major warns investors: “This is the biggest call you are going to make in European markets.”

Even 5 per cent yields would still be far below last summer’s peaks of almost 7 per cent, and Italy took the precaution of pre-funding much of this year’s financing need.

Analysts believed steps taken since Mario Monti became Italy’s technocrat prime minister in November 2011 in strengthening public finances and reforming Italy’s economy would remain in place.

The election outcome “shows how few Italians want to vote for further austerity,” says Ewen Cameron Watt, chief investment officer at Blackrock’s investment institute. However, on fiscal policy “most of the heavy lifting has been done.”

“If you have a protracted stalemate situation that ends up with new elections, the country would still remain in better shape than when Monti took charge,” says Marco Valli, chief eurozone economist at UniCredit in Milan.

Coalitions are part and parcel of Italian politics,” adds Alan Wilde, head of fixed income and currency at Baring Asset Management. “This [outcome] in itself is not going to send the market into a tailspin.”

Yet investors could take fright if fresh elections were held prematurely without reform of the system that produced Monday’s night’s deadlock. The strong showing by Beppe Grillo’s anti-establishment Five Star Movement has fuelled fears about rising anti-euro sentiment in the eurozone’s third-largest economy.

The broader danger is that Italy’s woes fuel fears about the fragility of Europe’s 14-year-old monetary union. “Investor sentiment in the eurozone has been brought back to earth with a jolt,” says Mr Callow. “The election has reminded everyone that these are democracies and governments have pushed at the limit of what is possible.”

Last July, Mario Draghi, European Central Bank president, calmed fears of a eurozone break-up by pledging to do “whatever it takes” to preserve its integrity.

Later he put in place a plan for “outright monetary transactions” by which the ECB would buy bonds of distressed eurozone governments.

But the OMT programme was not designed as protection against political instability or angry voters; Mr Draghi insisted governments would first have to sign up to externally approved structural and economic reforms – and Italy does not yet have an operating government.

Even before Italy’s elections, there were signs of increased nervousness over the inability of politicians to tackle crises across the 17-country bloc.

Near the top of those concerns is heavily indebted Cyprus, one of the eurozone’s tiniest members.

A decision by eurozone policy makers to impose losses on private sector investors in Cyprus, despite assurances that last year’s action on Greece would be unique, could trigger contagion across southern Europe.

Progress towards European banking and fiscal union remains slow.

The risks of the eurozone crisis re-erupting explain why rating agencies remain cautious – Moody’s has 14 out of the 17 members on negative outlook – and the prospects of a significant rebound in economic growth easing the region’s woes remain bleak.

Italy’s election, then, has served notice that progress in resolving the eurozone crisis will be subject to setbacks – sometimes significant. “It is a big spanner in the works,” says Gilles Moec, European economist at Deutsche Bank.

“It has tainted the story. The core story remains the same: we have better institutional arrangements and there is economic rebalancing. “What is missing is economic growth and the political peace and quiet we had expected in 2013.”

The calm before Italy’s elections may have encouraged complacency by politicians, Mr Moec adds. Tuesday’s market turmoil shows “the market discipline [on eurozone governments] always comes back.”

Additional reporting by Mary Watkins

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