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Brace for a bumpy ride in European stocks

The only certainty with Italy’s upcoming election will be un..

The only certainty with Italy’s upcoming election will be uncertainty.

Following Germany’s vote in September last year, it’s now the Italians who are headed to the ballot box this Sunday, with the outcome expected to be even messier than Berlin’s — which, incidentally, is still being pieced together by Chancellor Angela Merkel and her coalition partners.

Polls have pointed to a hung parliament where no one party will gain a majority to govern alone. But voter surveys have tended to be particularly misleading in Italy.

A centre-right coalition featuring Forza Italia, led by former Prime Minister Silvio Berlusconi, and Northern League – an anti-immigrant and anti-systemic party – is seen as being the strongest coalition. However, polls suggest that this alliance will still not get sufficient seats to form a majority government.

Lorenzo Codogno, an economist at LC Macro Advisors, put it bluntly in a research note at the end of last week: “The outcome of the Italian elections remains highly uncertain.”

His note traced how Italy became the most eurosceptic of all the Eurozone nations, and highlighted that immigration had become the main topic of the current political campaign. He also stated plainly that budgetary issues would be at the forefront of any winning party’s plans, and reminded readers that Italy still needed to find a solution to an “undercapitalised banking system burdened by a mountain of non-performing loans”.

Italy’s fragile economy is why this election is so very different to Germany’s, and why many analysts singled out this vote at the start of the year as being a major a risk factor for 2018.

Germany’s political mess caused little distress in European stock markets in 2017, but Italy is a different prospect.

UBS, which as a bank is quite bullish on these elections, offered a warning for equity investors. On Friday, a global research team at the Swiss bank said it “cannot fully rule out tail risk”, which could trigger a 10 to 15 per cent downside for Italian equities relative to other benchmarks in Europe.

The bank suggests that Italian sovereign bonds should be carefully watched and any sharp rise, when compared to Germany’s yields, is traditionally bad for the country’s equity markets.

“If spreads (the difference between the two yields) fall on a palatable outcome, Italian equities should do relatively well — and, of course, vice versa if spreads rise,” the team of analysts said in the note.

And guess what? Spreads are already rising ahead of the vote.

On Friday, Reuters noted that Italian 10-year bond yields were up 10 basis points last week, leaving the gap between those of benchmark eurozone issuer Germany at around 140 basis points.

The relative stock market robustness from Germany’s political disarray might not be so clean over in Italy.

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