Why the Italy-inspired selloff may be an overreaction

Euro coinsPhoto by Leslie Shaffer

Markets sold off globally in the wake of political uncertainty in Italy, but a Wells Fargo strategist said that ructions could be an over-reaction.

Fresh elections appear likely in Italy and that’s spurred fears the vote would turn into a referendum on whether the country will remain in the euro.

But Paul Christopher, head of global market strategy at Wells Fargo Investment Institute, said in a note on Wednesday that it was far from certain that the two populist parties which failed to form a government would post a better showing in the next election.

“In the fluid world of Italian politics, now that the stakes are known to be high, it may not be so certain that the populists would increase
their power in a new election, especially if Italy’s euro membership became the key election issue,” he said. “Italian public opinion remains in favor of keeping the euro,” he added, noting that leaving the common currency for a newly reconstituted lira could decimate Italians’ savings.

Christopher noted that investors were concerned that the two populist parties would dominate the next election and pressure eurozone officials for exemptions to allow the country to widen its budget deficit and reverse cost-saving reforms.

“Investors’ main worry is that Italian government bond prices may fall and yields rise, if the two populist parties eventually push through a program of wider deficit spending. In that case, Italian banks could also suffer, as they hold large quantities of public bonds in their portfolios,” he noted. “Concerns about the Italian banks’ exposure to Italian government debt sparked fear of contagion across Europe and dampened sentiment for U.S. and global financials.”

The euro lost ground, falling from around US$1.1734 on Friday to as low as US$1.1517 on Wednesday, but by around midnight Wednesday SGT, it was back up at US$1.1663.

Italy’s 10-year government bond yield spiked as high as 3.106 percent this week, from levels around 2.4 percent last week, which is no mean feat as the European Central Bank (ECB) continues its quantitative easing program. Bond yields move inversely to prices. The move in the two-year bond was no less stark: It spiked as high as 2.441 percent this week, from levels under 0.3 percent early last week, suggesting investors were more concerned about the government’s ability to pay nearer-term.

But Christopher said Wells Fargo still expected Europe to see broadly positive market trends and it kept a Neutral call on European equities.

“The euro’s recent weakness likely has been exaggerated and could partially reverse by later this year,” he added, although he said Wells Fargo was reviewing its target for the currency amid expectations it may not strengthen as much as originally forecast.

However, Christopher noted that volatility may remain high in the near term.