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Investing

Italy perceived as trouble — but not by all

Giuseppe Conte, Italy’s new prime minister, center, is now the head of the country’s potentially fractious political coalition and an unknown for investors.

Some seeing turmoil as offering opportunities

Money managers are carefully watching the political situation in Italy unfold, deeming the country "too big to fail."

But sources said they're not just watching for negative investment effects from the country's political and fiscal problems: They're also looking for opportunities to add to positions.

"Political risk is back with a vengeance in Italy," said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management in London. "As the third-largest global issuer of government bonds after the USA and Japan, Italy is too big to be allowed to fail without severe contagion to the global financial system. However, it is also too big to comfortably bail out using tried and tested mechanisms."

Recent weeks have seen Italy's population and investors forced to reckon with a populist government coalition and a potential snap election.

As the news unfolded, Italian bond yields moved higher, by more than 100 basis points in May and the Italian equity market was down about 11% since the start of May.

The current situation in Italy carries "similarities to the eurozone financial crisis" of 2011 and 2012, said Andrew Harman, London portfolio manager of First State Investments' diversified growth fund.

But that time the focus was on Greece. "Italy is the eurozone's third-largest economy and has a significant impact on the European Union and euro," Mr. Harman said.

The country's "new populist government brings with it a high degree of uncertainty, including introducing the potential of a referendum on euro membership. This crisis has the potential to be a short-lived political crisis, or a longer saga of currency redenomination (of the Italian lira), which would have much wider implications for global assets and economic prospects that far exceed Italy's borders," Mr. Harman said.

The diversified growth fund did not hold Italian debt up to June 4, with executives viewing the yields and spread to German bonds "too low to compensate for the investment risks." However, "with the significant increase in Italian yields, we added a long Italian/German spread position to the portfolio on ... (June 4). This will benefit if the spread between bonds in Italy and Germany narrows," he added.

Market weakness

Other managers took advantage of market weakness to add to positions. "The nature of the price action in Italian assets suggested panic and short-termism by market participants," said Tristan Hanson, multiasset fund manager at M&G Investments in London. "Risks are real, but hard to quantify and this can create a challenging environment for investors."

And for some, that means opportunities. "Sell-offs in Italian bond and equity markets improved the compensation on offer for some of the political risks," Mr. Hanson said. M&G's multiasset strategies have varying exposures to Italy, with one global target-return strategy having closed much of its Italian equity exposure in early May following "strong gains," but retaining exposure to Italian banks.

"In response to the market moves, I added exposure to the Italian banking sector" and also to a broader set of European banking stocks, Mr. Hanson said. He also added a new position in Italian 10-year treasuries, implemented vs. a short position in German government bonds "where yields had fallen to deeply unattractive levels."

Also altering positions were Cardano, which had a short Italian government bond position that it closed at a profit, said Annalisa Piazza, senior investment strategist in London. "We are still monitoring the political situation and may potentially add some protection for increasing political risks in Italy," Ms. Piazza said.

And Lukas Daalder, chief investment officer, investment solutions at Robeco in Rotterdam, Netherlands, said the firm is underweight Italian bonds and neutral equities. In mid-May executives "pre-emptively" moved to a short position on the euro vs. dollar, "as a hedge for the market's disregard for the political situation in Italy," Mr. Daalder said.

Some managers expect the situation to deteriorate. "In Italy, we expect sentiment to deteriorate as the new populist government tries to increase its budget deficit dramatically," said Joachim Klement, head of investment research at Fidante Partners in London. "This should lead to continued euro weakness and rising sovereign spreads for Italian government bonds as well as Italian banks and European banks with high exposure to Italy," Mr. Klement warned.

Little risk

But there is little risk for a full-blown euro crisis, as there is the possibility of financing new Italian sovereign debt at low costs and risk sharing with other eurozone member states, he said. Mr. Klement added that the European Central Bank is also "free to expand its bond purchasing program" — which is likely should sentiment deteriorate.

Whether they see opportunities or not, money managers agreed the situation in Italy is complex.

"Economically speaking, in a nutshell, Italy's problems are a high debt burden combined with weak and deteriorating demographics," said Kaspar Hense, portfolio manager in London at BlueBay Asset Management LLP. But Italy has achieved a "constituent primary budget surplus" and current account surplus — unlike Greece or Argentina more recently — which means the country is independent of foreign funding and does not need a currency devaluation to remain competitive.

However, "the situation remains fragile and volatility is high. We prefer to stay on the sidelines and have minor (or) benchmark positions only by adding tactically in weakness (in early June) and reducing at current levels," Mr. Hense said.

Italy's strong domestic and "multilateral institutional frameworks" were also cited by Robert Tipp, chief investment strategist at PGIM Fixed Income in New York. "In our base case, we expect Italy's assets to eventually retrace the recent sell-off and converge toward those from other peripheral countries."

Other managers said risks appear to have abated for contagion in Europe from Italy, thanks to the populist coalition not appearing "to be on firm ground yet, and also they did not individually call for a referendum on euro membership," said Gerrit Smit, partner, head of equity management at Stonehage Fleming Investment Management in London. "They probably have more focus on political survival not to trigger another election in a few months. This could otherwise have been an important risk factor seeing the relative size of the Italian economy," Mr. Smit added.

Faltering relationships

Hermes Investment Management executives also see the immediate crisis in Italy as having abated, but "we continue to see a meaningful risk of a worsening in relations between core Europe and the periphery," said Andrew Jackson, London-based head of fixed income. "We see the probability of a major eurozone crisis occurring as low."

Executives added to risk during the period of weakness "and broadly continue to hold that higher level of risk today," Mr. Jackson added.

And while Aberdeen Standard Investments' James Athey, senior investment manager in London, also thinks the risk of Italy's exit from the EU has reduced, caution remains toward Italian government bonds "given our expectation of a deteriorating fiscal situation requiring more (Italian government bonds) supply at a time when the ECB's (quantitative easing) purchases will soon be coming to a stop."

Executives were short Italy starting in February but have reduced the size of the short position "given the volatility," Mr. Athey said.

There are three issues to keep a close eye on, said Marika Dysenchuk, London-based fixed-income investment specialist at J.P. Morgan Asset Management (JPM): whether the coalition government remains on euroskeptic or raises the stakes to campaign for an exit; the viability of Italy's fiscal position given proposed spending plans; and whether the situation leads to ECB action.

Executives have been constructive on European peripheral government bonds for some time, and "have been tactically managing our allocation to Italy, particularly in our flexible, total-return portfolios. After holding a position in Italy for much of this year, we exited the position in advance" of the blocking of the appointment of a proposed finance minister by Italian President Sergio Matarella, Ms. Dysenchuk said.

"Developments over the past couple of days have made us increasingly comfortable that there is limited risk of Italy leaving the (eurozone)," Ms. Dysenchuk said. She expects the issue to shift to a more domestic one, adding some exposure to Spain and Portugal where spreads have widened "in sympathy with Italian political developments."