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If held a year ago, Italy’s inconclusive elections would have spelt disaster for the eurozone and financial markets.
Stalemate in Rome, voters’ rejection of fiscal austerity and the whiff of anti-euro ferment in the eurozone country with the second highest public debt level (after Greece) would have jolted bonds and equities globally. A week after the results, however, the market reaction is disappointing those bears who argue the world is on the brink of the next crisis.
True, election night saw a nervous cross-asset sell-off in New York, and Italian shares are down almost 2 per cent. But Italian 10-year bond yields traded on Tuesday below 4.8 per cent, up just 30 basis points from before polling day and far below last year’s peak of almost 7 per cent.
European equities have reversed losses; the FTSE Eurofirst 300 share index is up 2 per cent and at its highest since early 2011.
Global attention has switched back to the US – although deep budget cuts triggered late last week by Washington’s political impasse have not had much impact on investor sentiment either.
Is all this a sign that markets are becoming less stressed, less bewitched by the “risk on, risk off” herd mentality of the past few years – or a sign of dangerous complacency?
In Italy’s case, there are technical, countervailing forces supporting the bond market. With Italian debt offering attractive yields and important in many indices, a bigger setback would be needed to trigger a rush for the door. Barclays estimates net supply at just €30bn this year – so the choice for investors will be whether to roll over existing debt, rather than to increase exposure.
Ironically, Italy may benefit from the eurozone’s fragmentation, by which capital has retreated behind national borders. Domestic and European Central Bank holdings of Italian debt have increased to more than 65 per cent, from 50 per cent in mid-2011, reducing the dangers of capital flight. As yields headed towards 5 per cent, the risk for Italian banks was of missing a buying opportunity: where else could they put their money to get such returns?
Foreign investors, anyway, have given Italy the benefit of doubt. While Italy could be yet targeted by hedge fund shorts, London-based investment strategists point to progress made by Mario Monti, the technocrat prime minister appointed in November 2011, in turning the country around. Italy is expected to run a primary fiscal surplus (before interest payments) of more than 3 per cent of gross domestic product this year, while France still runs a deficit. Italy does not have the banking problems of Spain, nor its regional tensions.
Of course, Italy faces huge problems generating economic growth and improving competitiveness, but the crisis is not immediate – so no need to panic just yet. A rebellious, optimistic view is that Beppe Grillo’s anti-establishment Five Star Movement might shake up Italy’s discredited political system.
Another, rather circular, argument is that no matter how great the resistance from voters, pressure for reforms will remain because otherwise there will be a market sell-off.
But the biggest difference compared with a year ago is that Mario Draghi, ECB president, has removed the “tail risk” of a eurozone blow-up.
His “outright monetary transactions” plan, by which the ECB could buy distressed eurozone countries’ bonds, requires an externally approved reform programme. Some commentators argue that makes it irrelevant in Italy’s case – it may be months before Rome has a government capable of signing an agreement. But the consensus market view so far is that in a full-blown crisis, an administration would be formed.
Around the world, confidence in the healing powers of central bankers remains intact. In the past week, Japan’s share rally was extended on the expectation of more aggressive monetary policies after the nomination of Haruhiko Kuroda as Bank of Japan governor; Ben Bernanke, US Federal Reserve chairman, has reassured that US quantitative easing will remain firmly in place; and expectations have grown that the ECB will cut interest rates further to boost eurozone growth, although action this week still seems unlikely.
Against that backdrop, a single Italian election or the latest US fiscal twist are small parts of the story. It will take years if not decades for debt burdens to return to levels envisaged by the architects of Europe’s monetary union.
“You can’t go straight to fully pricing in ‘tail risks’ every time there is an election,” says Laurence Mutkin, head of rates strategy at Morgan Stanley.
Italian politicians have been given time by markets. But it seems a phoney peace.
Ralph Atkins is the Financial Times capital markets editor
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