European stocks drop as Italian coalition on the brink of collapse

Summary:

• Italy’s ruling populist coalition on the verge of collapse

• Vote of no confidence imminent; Elections probable

• ITA40 (-2%) falls to 2-month low; Contagion risks rising

Brexit aside, the political backdrop in Europe has been relatively tranquil for quite some time now but that looks set to change with the ruling coalition in Italy on the verge of collapse. What started with a failed attempt by the Five Star Movement to derail plans for a high-speed rail link between Turin and Lyon has revealed an irrevocable rupture within the government and not only does this mean that Italian’s will likely head back to the ballot box it also raises the spectre of broader political disruption throughout the EU. 

As the Eurozone’s third largest economy, Italy is a significant player in the bloc and the fallout from this threatens to have further reaching consequences.  The market has already reacted negatively to the news with the FTSE MIB (ITA40 on xStation) down more than 2% and the spread on Italian/German 10 year bonds (a closely watched measure of Italian political risk) has reached its highest level in a couple of months. With the contentious issue of the Italian budget due to be renegotiated next year this could become a bigger theme going forward and something that could impact not only equities and bonds but also the FX market through the Euro.   

Italian stocks sold-off both heading into the 2018 election and the announcement of the coalition. However, after both events the markets recovered in a type of sell-the-rumour-buy-the-fact trade. Source: xStation

The decision by deputy PM and leader of the League party Matteo Salvini to call for a snap election will effectively bring down the government and cause the collapse of the coalition that has only been in power for a little over a year. Whether an election actually occurs is still to be determined, with the calls from Mr. Salvini not necessarily meaning a poll, but this does seem the most likely course of action. Unofficial reports suggest October elections are a possibility but this remains unconfirmed at present. 

Italian stocks (ITA40 - green and red candles) led the way for lower the German Dax (DE30 - blue and transparent candles) in the second half of 2018. Will the recent weakness in Italy spill over into other markets? Source: xStation