Monday, February 25th, 2013

Unscrambling Italy

Making predictions about the impact of Italian elections is a mug’s game, especially when the votes have yet to be counted. Nobody knows who voted for what, and which coalition will running the country in a few days’ time. So there is only one thing worth talking about – the asymmetry built into current risk conditions.

At the moment, the volatility of almost every non-fixed income asset is at – or close to – the bottom of its two-year range. Markets have been calm and getting calmer. For US equities, trailing 26-week volatility is 12% compared with a two-year range of 10% to 22%: for Emerging Markets the equivalent numbers are 12% compared with 11% to 34%. For every other risk asset including Commodities, Real Estate and Japanese equities, the current reading and the range are broadly similar – every risk asset, that is, except one.

For European equities, trailing 26-week volatility (in USD) is 22% compared with a range of 17% to 46%. So Europe is not as close to the bottom of the range and the range itself is much higher than the others. The instability of Europe’s economy and the political risk posed by the Italian elections are well understood. Expectations are low. The head of Italy’s association of foreign banks is quoted in today’s FT saying that “a stable government would be a sort of miracle.”

Our model is based on the observation that investors are attracted to risk assets whenever the extra risk (excess volatility relative to bonds) of owning them declines. This also holds true when they are asked to choose between different risk assets. So if there is an asset class which has high and falling volatility, it has the potential to become progressively more attractive to investors.

So what about the asymmetry? If the Italian elections fail to produce a functioning government, the increased risk of a eurozone break-up may be enough to push the volatility of all risk assets higher in coming weeks. But if there is a “miracle”, the volatility of European equities and the euro/dollar exchange rate may decline. If the Italian elections are indecisive, there is downside risk for everyone. But if there is a workable coalition, European equities are the stand-out beneficiary. Stranger things have happened, even in Italy.

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