European markets steady on tenterhooks

Whether or not the rebound of European markets can last depends on how well a political fix in Italy supports the country’s banks, as they remain the fulcrum of financial pain from the referendum.

For now, the impact from Prime Minister Matteo Renzi losing the vote has been contained, allowing European stock markets outside of Italy, the euro and the pound, to recoup rapidly from Monday’s whipsaws.

More pointedly, bank shares in the UK and most of Europe were lodged in the black for most of Monday.

Whilst Renzi’s resignation will not necessarily trigger a European political crisis that sends markets into a tailspin, European bourses are now on tenterhooks because the shape of the government that emerges in Italy will go a long way towards deciding the fate of the country’s lenders.

Here are the key points to consider, in our view, before we know the outcome of a cabinet meeting, including President Sergio Mattarella, scheduled for 5.30pm London time on Monday:

• Renzi would normally be expected to remain as caretaker until a new PM is announced, whilst the likelihood of a snap election that could open the doors to right-leaning and anti-establishment political parties has receded considerably for now
• Mattarella is constitutionally obliged to propose the least politically destabilizing options first
• Current Economy Minister Pier Carlo Padoan, who hastily pulled out of meetings with European finance ministers in Brussels this week, will be present; Senate President Pietro Grasso and Transport Minister Graziano Delrio will too. The political rumour mill is active on all three, and Mattarella will be aware that the new PM needs the backing of Renzi’s Democratic Party to take office

Regardless of the outcome of talks with Renzi, prospects for extreme market volatility also appear to have decreased.

We note at least one of the biggest bears stalking Italian assets retreated on Monday. Allianz Global Investors (AGI) said it would reduce its short on Italian bonds which helped lifted bearish open interest to the highest since Europe’s sovereign debt crisis. AGI is lightening up as the spread between yields of Italian and German benchmark bonds holds well away from the most distressed breadth seen in recent history, and a recent 2-½ year peak of 190 basis points.

Overall, reinforced political and financial underpinnings provides a stable short-term backdrop for key negotiations over Italian bank recapitalisations to continue, even if the best possible outcomes are now more distant.

Risks have increased that we will see the less-favourable plan ‘B’ of state underwriting for the lender in the most perilous health, Banca Monte dei Paschi di Siena. The move will require bondholders to be roped in. That will leave less cash (and goodwill) among investors for UniCredit, which wants to reduce the size of a cash call— by means of asset sales—of as much as €13b

However, assuming a gruelling few weeks for markets has gone some way to over-pricing the risk of contagion, so long as the Italy’s political fudge sticks for the requisite two years before general elections, bank shares are unlikely to crater much further.

Still, for banks and European shares as a whole, much depends on signals that emerge from Rome over the next few hours, days and weeks.