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The Italian Job

07062018 the Italian job

The Italian Job

It was hard to miss the headlines and wild market reaction in the wake of the widespread narrative that Italy was preparing to leave the EU over the last couple of weeks. The lead-up to this was of course the Italian elections which produced a hung parliament on March 4, 2018 with the country spending months without leadership until anti-establishment “Five Star Movement” and the hard-right leaning “League” joined forces to form government in late May.

The catalyst for markets occurred when Italian President, Sergio Mattarella objected to the new coalition’s choice for Finance Minister, an 81-year-old economist (Paolo Savona) who had co-authored a “guide to leaving the Eurozone” and was seen as a proponent of breaking up the bloc. This action sent markets into a tailspin as media pundits speculated on the prospects of a “Brexit” style referendum on EU membership nicknamed by some as “Quitaly”. As an aside, Article 75 of the Italian Constitution forbids referendums opining on international treaties such as EU and Euro membership.

Despite this, interest rates on Italian 2-year bonds soared to levels not seen since the financial crisis (one of the largest percentage moves in history) and the Italian bond curve violently flattened (pink line in chart), with the market pulling the negative yielding front-end of the curve into positive territory and at last charging the country to borrow short term funds (rather than the reverse).

Screen Shot 2018-06-07 at 10.13.12 am

Source: The Daily Shot 

Screen Shot 2018-06-07 at 10.13.21 am

Source: The Daily Shot 

While we certainly do not claim to know how Italian politics will unfold or where the EU ultimately ends up, the situation is interesting in that the extraordinary market moves were entirely built upon a repricing of perceived risk, rather than an actual event. This is at the heart of the Montgomery Global investment process where we seek to understand what is priced into the market, whether the assumptions are reasonable and if there is an opportunity to profit.

With this in mind, bonds which have negative yields are truly a paradox for value investors, because buying such an instrument is guaranteed to lose money if the position is held to maturity. The only way to profit with such an investment is by hoping the bond can be sold to someone else at an even lower yield / interest rate before it matures (recall bond prices and yields move in opposite directions). This of course relies on a “greater fool” and is a milder version of the very famous Dutch tulip bubble in the 1600s which ended in devastation.

While Italy was not alone in having negative short-term interest rates (Germany, France, Spain, Portugal, et al still have negative rates), the market for the moment has called time on the situation for Italy, something that seemed more of an inevitability than a huge shock for us at Montgomery Global.

Amit joined Montgomery Global Investment Management in April 2018 as a Senior Research Analyst after spending seven years as a credit analyst at Credit Agricole and Citigroup, based in New York. Prior to this, Amit was an investment banker with Citigroup for five years in New York and Sydney, focusing on Media and Telecoms; Metals and Mining; and Consumer Products.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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