Even Berlusconi and Euroskeptics Can't Stop a Good Rally

(Bloomberg) -- With a euroskeptic and a controversial media titan angling for control of Italy’s government, Sunday’s election seemed to offer enough political risk to put markets on edge. Yet there’s been little sign of investors willing to get in the way of a good rally.

Italy’s main stock benchmark is up 4 percent for the year. In the currency market, there’s little sign of the angst about a polarizing European election seen ahead of France’s ballot last May, looking at hedging costs for a drop in the euro. And the premium on Italian bonds over German peers has been retreating in the campaign’s final week.

That’s despite the prospect of a hung parliament that leaves Silvio Berlusconi, the former prime minister convicted of tax fraud, as likely kingmaker. Given his ban from being titular head of government, the result could be an uneasy alliance with the euroskeptic Northern League, if the two blocs can resolve differences.

“The formation of a weak government is not a huge concern for the financial markets, which are cheered by the ongoing cyclical upswing in Europe,” Nicola Mai, head of European sovereign credit research at Pacific Investment Management Co. in London, wrote in a note.

Not everyone is convinced things will go smoothly. Bank of America Corp. strategists have told clients they should cut exposure to Italian corporate debt. Bonds of many Italian energy, utility and transport companies are yielding less than sovereign debt; a re-evaluation may be at hand.

“These pockets of the credit market are more susceptible to widening,” Barnaby Martin, a credit strategist at the bank in London, wrote in a Feb. 23 note to clients. The backdrop of a reduced European Central Bank stimulus program means the asset purchases “may not frustrate credit shorts as much as they did around last year’s French elections.”

Citigroup Inc. has warned of prospects of a spendthrift administration.

“All of the economic proposals discussed ahead of the elections point in one direction: a sharp increase in public debt,” Citigroup strategist Mauro Baragiola said in a Feb. 26 note. Investors “tend to forget that the most likely scenario is a government somewhat led by Silvio Berlusconi, of whom markets used to not be big fans in the past,” he said.

Some may be taking those risks to heart -- options markets are signaling an increase in costs to hedge future bond volatility.

Various tax-cut promises may ultimately not sit well with investors in a country where a fragile economic recovery is weighed down by a debt ratio second only to Greece in the 19-nation euro area.

But Italy has has faced down debt concerns before, and some analysts conclude that a new cast of characters in office won’t amount to much change. Barclays Plc and Morgan Stanley have recommended bullish trades on Italian bonds.

“The most likely outcomes of the Italian elections are wide and heterogeneous government coalitions,” wrote Barclays analyst Cagdas Aksu. “We would perceive these outcomes as likely to result in Italy performing well, with spreads tightening versus Germany, as well as Spain.”

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