Institutional investors are keeping an eye on the political instability in Italy as premier-designate Carlo Cottarelli prepares to present his ministerial picks and the market opened down 1.8 per cent on Tuesday.

Last week, Italy’s president Sergio Mattarella invited the anti-establishment Five Star Movement and the League, formerly known as the Northern League, to form a coalition government. That would have led Italy to a more populist leadership than markets had been anticipating, according to Ken Orchard, a senior portfolio manager in the fixed-income division at T. Rowe Price Group Inc. However, the tide turned over the weekend when Mattarella vetoed the parties’ choice for finance minister, former industry minister and euro-detractor Paolo Savona, causing them to drop their plans for power.

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Instead, Mattarella appointed Cottarelli, a former executive director of the International Monetary Fund, as premier-designate, with the primary goal of passing Italy’s next federal budget while preparing for a snap election to take place later this year or in early 2019.

With Italy’s politicians back on the campaign trail, the country’s financial markets have been jumpy in recent weeks. The FTSE Milano Italia Borsa index rose 0.8 per cent off the prospect of a coalition, but losses throughout the month still leave the index sitting down around four per cent.

The possibility of such a populist government, as well as more generalized worries about instability, were already priced into the markets to a certain extent, resulting in a more mild downturn, says Orchard. “People were generally underweight Italy at that time because a lot of people had underweighted or shorted Italy ahead of the election thinking that if we have this bad outcome, it is going to lead to a big sell-off.”

Within the bond market, however, Italy may have seemed like a decent alternative with U.S. bond yields on the rise, he says. Italy’s bond market had recently seen new investors who were caught off guard by the election outcome and sought to unwind some of their positions, pushing prices down and yields higher, says Orchard. Regardless of the recent sell-off, though, yields remain lower than they’ve been in recent years and Italy is gradually reducing its very high levels of debt, he notes.

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As well, investors aren’t as concerned as expected by Italy’s ongoing political upheaval, noted Nicola Mai, executive vice-president at PIMCO’s London, England, office, in a recent blog. One reason, he suggested, is that dramatic political events have lost some of their shock value in the wake of Donald Trump’s presidency and Britain’s vote to leave the European Union.

It remains unclear who Italy’s finance minister will be, but anyone with an unfavourable tone towards the euro would be problematic, says Orchard. While leaving the European Union would be difficult for Italy, a finance minister who’s actively trying to undermine the country’s commitment to the currency would be cause for concern, he notes. “It’s a low probability outcome, but it’s something that is lurking, ” he says.

While Italy is Europe’s third-largest economy, Canadian pension plan exposure to the region isn’t an overwhelming trend. As of March 31, 2017, the Canada Pension Plan Investment Board held about $820 million worth of Italian stocks, making up less than one per cent of its overall foreign equity exposure. On the private equity side, the Ontario Teachers’ Pension Plan purchased a minority stake in Italy-based cosmetics manufacturer Intercos in August 2017.

As well, emerging markets may steal investor attention from Italy as the political drama continues to play out, noted Orchard. “When we look at Italy on a relative-value basis versus emerging markets of similar credit quality, we just think that the relative value is much, much better,” he says. “If we compare Italy to Indonesia, for example, it has probably got better long-term fundamentals . . . so there’s the potential for much higher returns.”

Read: Ontario Teachers’ buys stake in Italian cosmetics manufacturer

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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