Italian populist parties close to a deal

This week, Italian politics will be in the focus. The Five Star Movement and the Lega have intensified talks over government formation and seem close to a deal.
We expect BTP-Bund spreads to increase moderately over the coming months. That said, a more significant widening would likely require the actual implementation of deficit-increasing measures or a deterioration in the global growth environment.

Last week, core yields were marginally up, with the US yield curve flattening to the most since August 2007. At the same time, equity markets extended their positive streak. The MSCI EMU was up by 1.1% (in total return terms), the seventh weekly increase in a row, as euro area macro surprises showed signs of bottoming, albeit at very low levels. The S&P 500 (+2.5%) and the FTSE 100 (+2.4%) outperformer, while the Japanese Topix increased by a more modest 1.1%. In the Emerging Markets (EM) arena, Chinese equities were strongly up (+4.2%) thanks to a pickup in macro surprises and the upcoming inclusion of China A-shares in the MSCI EM index. On the contrary, Turkey and Argentina’s assets continued to suffer, with the latter approaching the IMF in order to secure a credit line to stop the collapse of the peso.

Another key event of the past week was President Trump’s decision to withdraw from the Iran’s nuclear deal. This led to a further increase in oil prices, with the Brent surpassing US$ 77 per barrel, the highest level since November 2014. This favored a strong performance for both energy equities and bonds. In terms of macroeconomic implications, however, the rise in oil prices will likely contribute to a more marked increase in headline inflation in the coming months, and this could eventually weigh on households’ real disposable income and consumer spending.

This week, investors will like keep an eye on political developments in Italy. After President Mattarella hinted to a “neutral” government following a 2-month long deadlock, the Five Star Movement (M5S) and the Lega intensified negotiations. Mr. Berlusconi stepped aside to facilitate the deal, although he announced that Forza Italia will not vote the confidence to a M5S-Lega cabinet. We deem such a solution as the only plausible alternative to snap elections later this year.

The increased chances of a populist government started to weigh on Italian assets. Last week, the 10-year BTP-Bund spread increased to 132 bps (+7 bps in a week). Looking forward, we expect some further moderate widening. That said, the actual implementation of deficit-increasing measures and, even more importantly, a deterioration in the global growth environment would be required in order to trigger a more significant correction in Italian assets.