As the likelihood of a new Italian coalition government continues to solidify, institutional investors are watching the country’s extremely volatile bond markets.

The hard-left Five Star Movement and centre-left Democratic Party have joined forces to avoid snap elections, which would have strongly reinforced the power of Matteo Salvini, the leader of Italy’s far-right League party, says Stephane Dutu, director and fundamental analyst in equities at Unigestion.

He says the new government will be less unstable than its predecessor — a Five Star and League coalition that ended recently when Salvini withdrew his support after 14 months in power. Shortly after, Giuseppe Conte, prime minister and leader of the Five Star party, resigned.

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While the coalition hasn’t yet been finalized, the probability it succeeds is more than 50 per cent, notes Dutu.

He also predicts the main source of any clash between the parties will be corruption, which is endemic in Italy. Five Star scored very highly in the 2018 general elections — with more than 30 per cent — because of its promise to fight this issue, adds Dutu, noting the Democratic Party is one of the parties most associated with corruption.

As well, the new government is more likely to be beneficial for the European Union, since the EU can rely on the Democratic Party to impose its requirements, says Dutu. “The combination of these parties will be less confrontational with the EU than the old coalition.”

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Even though Five Star’s messaging was heavily populist when it was founded, its 10 years in government has moved it closer to the establishment, says Matteo Ramenghi, chief investment officer at UBS Wealth Management Italy. The party’s latest statements confirm it’s pro-Europe, he adds, noting the party is now more predictable and seen as less of a red flag for investors. “The new coalition’s support for Italy, the Euro and the EU is high.”

If the new government is approved, it could continue to be a market driver, says Ramenghi. Before the collapse of the former coalition, Italy had a bond yield of 1.8 per cent in comparison to Spain and Portugal, which were both below 0.2 per cent, he adds. “It’s essentially a political issue — question marks investors had about the League’s fiscal policy and their commitment to Europe.”

He emphasizes the magnitude of the move in Italian government bonds since the new coalition came into view, with yields ticking down to one per cent from 1.8 per cent just a few weeks ago.

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It’s also likely Italian equities would see an upswing off the back of the new government since its market is tilted towards the financial sector and therefore highly correlated with the health of Italian fixed income, says Dutu. Also, because this government is expected to be less unstable than its predecessor, it should raise corporate spirits, he adds.

“Because the Democratic Party is entering the coalition, currency redenomination risk is falling. Therefore, the future of Italy in the EU is not going to be questioned. That’s very positive for bond holders.”

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

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