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With ‘Frexit’ looking like it is off the cards, investors attuned to political risk in the eurozone are turning their attentions back on Italy.

Italian assets are enjoying a bounce today, caught up in the broader market euphoria over Emmanuel Macron’s likely ascendancy to the French presidency in less than two weeks’ time.

Mr Macron, who won the largest vote share in the first round presidential vote yesterday, is on course to defeat his far-right rival Marine Le Pen according to polling which suggests he will cruise to a comfortable 60 per cent majority and become the country’s youngest ever head of state.

French stocks, bonds and the euro are all rallying strongly today with investor demand for eurozone assets up across the board.

Outside France, Italy is a particular bright spot as markets bet the fate of the eurozone’s third largest economy inside monetary union could prove more secure under a vision for a strengthened EU as supported by Mr Macron.

Italy’s benchmark FTSE MIB is up 3.7 per cent this morning – putting it on course for its best day since December (when the restructuring of one of its major banks was approved) – while the country’s 10-year yields are down over 10 basis points (0.1 percentage points).

The benchmark yield, which falls when a bonds prices rises and reflects the country’ borrowing costs, is down to a monthly low of 0.21 per cent

Analysts at Bank of American Merrill Lynch expect eurozone banks, Italian assets and domestic French stocks to all benefit “as Frexit risks diminish and confidence in the economic recovery is bolstered”.

But as political risk in France fades, investors are likely to take a dim view on Italy’s longer term economic prospects – including a debt pile of 130 per cent of GDP, a struggling banking sector, and stagnant economy, according to Richard McGuire at Rabobank.

“France is downgraded in terms of being one of the market’s principal concerns, another source of worry will take its place”, warns Mr McGuire, who expects Italian debt to underperform its major European peers.

Italian risks include a looming general election, which will take place in the next 12 months, and the country’s persistent vulnerability to a scale back of the European Central Bank’s quantitative easing policies.

Rating agency Fitch cut Italy’s sovereign borrower rating to just two notches above junk last Friday, citing the government’s near-constant failure to meet its budget targets and cut a debt load which is the second highest in the eurozone after Greece.

Combined, these developments have “left Italy more exposed to potential adverse shocks” said Fitch. “This is compounded by an increase in political risk and ongoing weakness in the banking sector which has required planned public intervention in three banks since December”.

Kim Liu, senior rates strategist at ABN Amro, thinks the current bout of bondholder optimism over Italy may be overdone. He expects the ECB to make no significant policy shifts at its latest governing council meeting on Thursday but the central bank should pave the way for a shift in its language around June – threatening the outlook for Italian bonds.

“With the benign French outcome, the ECB is free to continue moving towards the QE exit”, said Mr Liu.

“These factors make Italian bonds particularly vulnerable and should put Italian spreads under renewed pressure.”

Mr McGuire at Rabobank adds: “The market’s very warm response to the first round of the French presidential election means the risks in terms of eurozone spreads are highly asymmetric with additional upside looking limited but the downside looming larger”.

“Positioning for an underperformance of Italian bonds looks to be the obvious trade.”

Copyright The Financial Times Limited 2017. All rights reserved.
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