Legg Mason: Fixed income markets complacent over ‘Italexit’ election outcome

Investors are too complacent about the outcome of the upcoming election in Italy this weekend, with a very real risk of a euro-sceptic government being formed, according to Legg Mason’s affiliates.
The impending election has had little impact on fixed income markets as yet, with Italian sovereign debt yields lower than at the start of the year.
Current yields on 5-year Italian sovereigns are at 0.727%, notably below levels seen in December when they fell to 0.781% before bouncing, while 10-year yields have also moved back towards lows seen that month.
Paul Ehrlichman, Head of Global Value at Legg Mason affiliate ClearBridge Investments, said markets were not pricing in any possibility of an anti-EU government forming as yet.
“As the March 4th Italian election approaches, it appears that investors are somewhat complacent about the outcome,” he said. “Markets are prepared for an uncertain result, but one that does not threaten the building eurozone economic recovery or the single currency.
“But while we also see a hung parliament and continuation of the caretaker government as the most likely result, there is a good chance of a more disruptive scenario emerging.”
Ehrlichman said the main battle in Italy is between a resurrected Silvio Berlusconi and his right-wing coalition and the anti-establishment Five Star Movement, led by the 31-year-old Luigi Di Maio. Both are tapping into the fear and anger over Brussels-imposed austerity and immigration.
Berlusconi needs to capture at least 40% of the seats in parliament to form a government but even then, the infighting between the far-right and more centrist members of his coalition could prove problematic.
However, the largest single block on course to win seats is the Five Star Movement, which is beginning to back away from its original “no coalition” stance.
“The challenge for Di Maio is that he still wants to be PM and is offering no ministerial seats in return for joining his voting bloc,” said Ehrlichman. “If he abandons these unworkable preconditions and wins a large proportion of the vote, then a partnership with the Northern League is possible. This would be highly destabilizing to the markets since both groups are historically anti-eurozone.
“Regardless of the specific election outcome, ranging from caretaker to right-wing ‘Italexit,’ we are concerned that a populist platform of higher government spending, lower taxes and increased confrontation with the EU is likely. In the context of a more receptive and economically healthy Europe, this is more of a threat to bonds than equities in the short run.”
Patrick Bradley, Senior Vice President of Investment Research at Brandywine, agreed the market was signalling a continuation of the status quo, unlike last year’s reaction to the French election, thus leaving itself exposed to any other result.
“Currently, the spreads between Italian BTPs and German bunds are compressing—compare that to last year when there was real uncertainty heading into the French elections and OAT-bund spreads were widening,” he said.
“The market, at least for now, is signalling that investors have a handle on what the Italian elections could ultimately yield: some type of coalition government. However, the risk here would be a euro-sceptic government.”
Andrew Cormack, Portfolio Manager at Western Asset, added that while the most market friendly outcome – of a hung parliament – remained the most likely outcome, there were no clear trading opportunities around such an outcome.
“We think this market friendly outcome is almost fully priced into Italian bonds, with the 10yr spread at 135bps over Germany,” he said. “We have been less constructive on Italy given recent valuations and go into Sunday’s election with a neutral opinion.