Are Italian markets too relaxed

If the mid-week European stock market rally signalled that sell-offs ahead of Italy’s referendum were overdone, slides by key indices on Thursday showed complacency remained a risk.

Ironically, the stock market at the root of resurgent anxiety, Italy’s FTSE MIB, closed 1% higher, as the country’s beleaguered banks rallied 2.6% following a 3% rise a day before. Stronger than expected GDP figures on Thursday helped, as did reports that the ECB would temporarily increase purchases of Italian bonds in the event of a run.

But Italy’s bank shares remain at the crux of difficulties in discerning how much further risk is at stake for markets. To be sure, pessimism prevails over Prime Minister Matteo Renzi’s chances of winning approval for proposals to trim Italy’s upper house and claw back powers from the regions. And following two political shocks that left them offside, this time, pollsters are pointing to a win for the anti-establishment vote. But the establishment view, voiced by several economic and political institutes we have contacted in the country, is that another one of Italy’s frequent political upsets would not do markets much harm.

Italy’s main stock index has, after all, already tanked more than 20% this year, easily the worst performance by a developed market in the single-currency trading bloc.

However, with bearish open interest in benchmark Italian government bonds (BTPs) at its highest since Europe’s sovereign debt crisis, according to Thomson Reuters data, the alternative interpretation—that markets are still underestimating risks from Sunday’s outcome—may yet prove correct. Italian banks, with links to $377bn problem loans on their books that span the globe, could still make their presence felt more clearly outside of the country. They also own €405bn or 21.6% of all Italian government debt.

Yet the gap between 10-year Italian and German bond yields is holding at around 2 percentage points. Even after the premium on Italian paper ground about 50 basis points higher since the beginning of October, the spread does not show debt investors are expecting a deeper devaluation of the euro anytime soon.

This stable if not unconcerned picture leaves Italian assets still vulnerable to a short sharp shock at least, should key markets gap widely enough to spread alarm.

Volatility would probably fan out from bank shares.

The weakest banks in the rest of Europe would then be eyed. We could expect Deutsche Bank, Commerzbank, RBS, UBS, and others to be in the frame.

Assuming heightened anxieties about Eurosceptic sentiment, already low-flying airlines shares, Lufthansa, EasyJet and ICAG, may face further flak.

All this said, the riskiest combination of events from the market’s point of view is still the one that appears least likely:

• Renzi’s exit
• Failure of the President to cobble together a new administration from the remnants of the former one
• Resulting in a 70-day deadline for an election to be called
• And paving the way for a possible win by anti-euro/EU parties like Five Star and Forza Italia

• Instead, the new administration is more likely to resemble Renzi’s, assuming his coalition partners support a new pick for PM from the ruling Democratic Party by Italy’s President
• The new PM will remain in place until the next general election, no later than 23rd May 2018
• That relatively smooth political transition would mean that any severe market dislocation would pass quickly

However, it will be difficult to put volatility back in the bottle regardless of the outcome of the referendum.

A new law, the so-called “Italicum” currently under consideration by the Constitutional Court, would allow the most popular party in an election a majority in Italy’s lower house of parliament even if it didn’t win a majority of votes. The ruling will be revealed after the referendum.

With anti-establishment sentiment spreading, Italy’s economy weaker since 2013 and Five Star polling strongly, it is a question of ‘when’ the next significant upsurge in volatility comes, not ‘if’.