Strategy: Risk off? Yes - but both Italy and EM issue to be contained

In a week where risk sentiment soured markedly on the prospect of a debt-willing coalition government in Italy, and a continued stream of negative data surprises out of notably the eurozone, the unabated rise in US 10Y yields seemingly came to an at least temporary halt. While the latter may spur some provisional relief for emerging markets, the euro area is set to face near-term headwinds still from the Italian issue hitting at an unpleasant time of cyclical weakness. Indeed, even as US yields may be taking a breather, there may be more USD strength in store short term. Indeed, our quantitative cyclical lead models continue to hint that the US holds a relatively favourable cyclical position. Hence, risk sentiment could suffer for some time still despite more signs of trade-war relief this week.

Italy unlikely to spur new euro debt crisis

Following complacency in the immediate aftermath of the election, markets have over the past week been hit hard by renewed Italian debt worries as the two anti-establishment parties Five-Star Movement and Northern League are set to form a government with technocrat Giuseppe Conte as prime minister. The appointment of a new finance minister will be key to the market direction from here, but it is clear from the draft programme laid out by the parties that the new government plans a fiscal expansion of 6-7% of GDP.

Crucially, we do not see recent developments as the start of a new euro debt crisis. First, we think it will be difficult for the coalition government to fully implement this though as i.) budgetary measures require approval in both chambers of parliament and this may prove difficult to achieve, not least due to possible defections in the face of rising market pressure on Italian yields, and ii.) president Mattarella will likely play an active role in ensuring fiscal and political sustainability and accordance with international treaties of any new bills. Second, Italy is somewhat different now than just a few years back: i.) both foreigners and Italian banks have reduced their exposure to Italian government debt markedly, ii.) rating-wise Italian bonds remain comfortably above ‘junk' status with all rating agencies and thus still easily qualify as collateral in ECB auctions. That said, until more clarity regarding actual policy implementation is obtained, an Italy risk premium will likely continue to depress sentiment in the eurozone and weigh on the single currency.

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