Investors are sticking to their guns and remaining bullish on European equities despite a flurry of potentially disruptive political developments in Spain and Italy, according to several fund managers and analysts.
In Italy, a coalition of populist parties that have previously promoted eurosceptic lines – League and Five Star Movement (MS5) – have formed a government after three months of a hung parliament.
Italian markets took a tumble in the time leading up to this with equity markets down 10 per cent at one point and 10-year government bond yields jumping over 100 basis points in the space of two weeks.
Italian 10-year government bond yield over the past month
Source: Bloomberg
However, European investors seem to be unphased by this political upheaval in the longer-term.
GAM investment director and FE Alpha Manager Niall Gallagher said he doesn’t believe the political turbulence in Italy will have an impact on the other eurozone economies outside of the banking sector and Italy itself.
“While we may experience several months of ‘noise’ we are confident that the positive outlook for European equities remains intact,” he added.
Pictet Asset Management chief strategist Luca Paolini said he is also still feeling bullish on European equities and that there’s “no need to panic as yet”.
“We stay overweight eurozone equities, which should benefit as the economic and earnings cycles catch up to those in the US,” Paolini explained.
"Plenty of bad news is already in the price of the region's stocks and the euro’s relative weakness should offer additional support.”
The Pictet chief strategist did admit, however, that this outlook is subject to how the situation in Italy develops.
“There’s a possibility the populists’ coalition could yet be proven strongly anti-EU, leading to further bond and equity market losses,” he explained.
The new coalition has vowed to take a firm stance on the EU and some say it could be on a collision course with the bloc.
Yet, this is not the base case scenario for many managers and strategists.
Paolini noted: “We think the new government is likely to be less market unfriendly than initially feared and we don’t expect the Italian political crisis to pose a systemic threat to the region’s banking system.”
He said many European banks do hold large amounts of Italian sovereign debt that is “bigger than their capital buffers.”
However, the political uncertainty in Italy paired with the recent changes in Spain – as detailed below – have prompted the Pictet strategist to short the euro currency and increase exposure to the Swiss franc, which is at its cheapest since the financial crisis.
The second major political event to take place in Europe last week was in Spain, where centre-right prime minister Mariano Rajoy was ousted following a vote of no confidence and was replaced by socialist Pedro Sánchez.
Investors showed little interest in this and, in fact, the installation of the new government gave markets a small boost with the major markets up by Friday’s close after the vote.
Performance of markets between 28 May – 4 June
Source: FE Analytics
Schroder’s senior European economist and strategist Azad Zangana said such a movement in markets could potentially be attributed to the new prime minister’s lack of political power.
“Compared to Rajoy’s party, Sánchez is even more dependent on the backing from other parties to push through any significant change,” he explained.
Zangana added that Spain’s stable economic condition has helped keep markets steady.
He said: “The other reason for relative calm on events in Spain is that the kingdom has enjoyed strong growth in recent years, a significant improvement in its annual deficit, and its debt sustainability is not in question.”
The Schroders economist view on Italy is not so positive, however, where he sees a potential disaster on the horizon if the coalition’s economic programme is put in place.
Zangana said the country’s finances could be led down an “unsustainable path” and could lead to another government debt crisis, which has the potential to also affect the wider eurozone.
“For Europe more widely, the impact from an Italian debt crisis would be severe,” he explained. “As the third largest member state, Italy would simply be too big to bail-out for any significant period of time.”
Yet, Zangana said this is not something to worry about in the near future but noted that there is no “quick fix on the horizon”.
Conversely, GAM’s Gallagher was more positive on Italy, adding: “Recent economic evidence, combined with evidence from our meetings with Italian and European corporates, suggest the Italian economy is continuing to recover and the extent of this recovery is probably stronger than is being reflected in economic data.”
Indeed, Italy is currently running a trade surplus with the rest of the world which represents 2.7 per cent of the country’s gross domestic product (GDP).
Italy’s current account balance
Source: FE Analytics
With regards to the political upheaval, GAM’s Gallagher said that this sort of political change is the norm in Italy now – highlighting the country’s 23 prime ministers since 1980 with six in the UK – and that it probably wouldn’t have much of an effect on investor sentiment.
He added “Anecdotal evidence suggests changes in consumer and investing behaviour in Italy emanating from political volatility are unlikely.”