The nervous reaction of investors to political developments in Italy highlights concerns over the implications for Eurozone stability. While it is too early to have a clear view of how the situation will develop, we believe that now is the time for investors to assess their exposure to European assets, especially Italy and the rest of the periphery.

With Italy close to forming a Eurosceptic, populist coalition government – one that would reduce taxes, increase spending and openly question the rules and agreements imposed by European institutions – increased friction in the EU seems likely.

This situation is reminiscent of the events that rattled Greece in 2015 following the election of the Syriza government. However, Italy is the third-largest economy in the Eurozone. And with Italian government debt accounting for a little more than 20% of the total government debt issued by Eurozone countries, together with Italy’s sizeable banking system, the stakes are higher.

While the new Italian government’s policies are likely to create friction with the EU and to increase uncertainty over whether Italy might leave the euro, we believe at this point that it will not lead to a major crisis. That said, investors would be ill-advised to ignore the issue.

Investment implications

We believe that: 

• Investors need to be ready for the possibility of a further increase in Italian bond yields, widening of spreads and equity market underperformance in Europe, given the high level of uncertainty that is likely to persist in the absence of changes in government policy.

• There are also likely to be increased tensions in the banking sector. This uncertainty could put downward pressure on the euro against other major currencies.

• The heightened uncertainty and the risk to the stability of the common currency could delay any policy changes by the ECB.

• The situation could have a spillover effect on Brexit: on one hand, the EU – busy sorting out a possible Italian economic crisis – might soften its stance on Brexit; on the other hand, it might lose patience and make a take-it-or-leave-it offer. Either way, increased tensions in Europe and the risk of a crisis would likely bolster support for the Brexiteers’ view that the only way out of the EU is a clean break, thus increasing somewhat the risk of a hard Brexit, in our view.

• Investors should carefully assess their exposure to European assets, especially Italy and the rest of the periphery.

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For professional investor use only.
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
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