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Goldman Explains Why “We Would Fade The Recent Rally In Italian Assets”

Courtesy of ZeroHedge. View original post here.

One look at the reaction in Italian assets this morning following the formation of a 5-Star/League coalition government in which the "worst case" was averted, and euroskeptic Paolo Savona was prevented from becoming FinMin, that honor instead falling to another closet euroskeptic, Giovanni Tria, and all one sees is euphoria, with the Italian FTSE MIB stock index higher by 2.8%, rallying the most since the end of February and recouping much of its losses for the week…

… while the Italian 2Y yield dropped low as 0.66% this morning, after rising as high as 2.841% on Tuesday.

And yet, according to Goldman, the market's euphoria is all wrong as the bank "would fade the recent market rally in Italian assets."

As Goldman's Silvia Ardagna explains, while markets have rallied in anticipation of the formation of the coalition government on the basis that it removes the near-term risk and uncertainty associated with new elections as early as July, this is a major gamble, as "based on recent polling, new elections could result in an even stronger victory for the populist parties, which we expect would raise investor concerns that a more aggressive populist agenda as embodied in the coalition agreement – possibly including risks to Italy’s continued participation in the Euro area – could be in prospect."

As a result, in Goldman's view, "a positive reaction to the potential formation of coalition government between Lega and 5SM is misplaced" for these three reasons:

  • First, based on recent political events, it is not clear how long the coalition government will last. At the very least, with opinion polls showing a substantial increase in support for Lega over the past week, Matteo Salvini (its leader) has a clear incentive to seek early elections in the autumn
  • Second, even though the coalition agreement between Lega and 5SM does not envisage Italy exiting the Euro area, in our view a more confrontational relationship between Italy and the European institutions and partners is likely to emerge under the new coalition government, especially as regards fiscal and immigration policy. Such confrontation would likely see investors continue to question the new government's commitment to respecting EU rules and thereby sustain uncertainty about Italy’s participation in the Euro area.
  • Third, if the coalition government carries out fiscal policies as indicated in the already agreed programme, we think any increase in economic growth would be limited, and public debt would again be placed on a rising trend again, which would increase investor concerns and potentially result in rating downgrades.

Meanwhile, a number of immediate challenges will face the new government.

  • First, to avoid an automatic increase in VAT (which existing legislation demands), the government needs to implement fiscal tightening measures worth EUR12bn in 2019 and around EUR19bn in 2020 and 2021.
  • Second, the new government will need to prepare and discuss with the European Commission a budget law by early October. Third, the new government will participate at the European Summit in June, where developments on the institutional upgrade of the Euro area are on the agenda. At that time, the new Italian government might put forward its own proposals for reform of the European Union, likely involving less stringent design and application of fiscal rules, as well as strong measures to control and reverse immigration. The nature of its proposals and the attitude it adopts towards other Member States and the European institutions will be a litmus test of its approach to Italy’s participation in the European project.

Another bank joined Goldman's skeptical take, with SocGen Ciaran O’Hagan, head of European rates strategy writing that Italy’s new government is still seen to be dangerous for long BTP positions with the possibility of more forced selling, ratings downgrades and capital outflows. Some more details from his note via BBG:

  • New coalition government of League and Five-Star places the market back almost to the same situation last week
  • Don’t expect the newly formed government to hold for more than a few months, which means elections can only be held in September at the earliest
  • Populist parties have stated their intention to want to keep the euro, it is unclear how fast they will discuss measures which are incompatible with euro area membership
  • Strong chance of an early downgrade from Moody’s after latest move to negative watch, probably within weeks
  • Too early to expect capital outflows in summer, though when they do start, this could be prelude to capital controls, sharp rise in BTP yields and further ratings action
  • Expect more risk adjustments given the huge volatility, with bid/offer spreads on BTP futures "stunningly wide", impossible to justify long positions in 2- to 5-year given the volatility

As a result, SocGen recommends using rebound in Italian bonds to establish new shorts.

* * *

Yet while Goldman is clearly bearish on Italian developments, it is far more optimistic on the government change which also took place today over in Spain, where now former Prime Minister Rajoy was replaced by Socialist leader Pedro Sánchez.

In our view, the change of government is unlikely to disrupt the Spanish economy. We thus continue to forecast robust economic growth in Spain over our forecast horizon. Separately, the Financial Times reported that Mr. Sánchez would "re-establish dialogue” with the new pro-independence government in Catalonia.

The risk to this view is that Mr. Rajoy resigns before the no-confidence vote goes through, which would see new elections take place. Opinion polls taken in the past two weeks indicate that Ciudadanos (a liberal party) is leading (at 26.4%), with PP and PSOE neck-and-neck a little behind (at 21.2% and 21.9%, respectively) and Podemos at 17.5%. New elections would likely lead to another hung Parliament and, as a result, it could take time to form a new government. That said, in Spain we see no risk that parties potentially forming government would question the participation of Spain in the European Union. As such, political uncertainty stemming from a new election and its aftermath should not derail broadly positive market sentiment towards the country.

Now the question is whether this is Goldman being honest with its assessment, or merely unloading prop exposure, in which case what the above really means is that one should be buying Italian bonds with both hands and on margin, doing the same as Goldman's prop traders, while shorting the living daylight outs of Spain's new unstable, minority government.


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