Major surprises for markets in 2017 include the recovery of the euro against all major currencies, especially the dollar, and the Italian stock exchange that recorded the best performance in the eurozone. These are issues closely connected to each other in a delicate balance: on the one hand, the strength of the euro can act as a brake on Italian exports, on the other, Italy is the third largest economy in the eurozone and its health (both economic and politics) affects the interest of investors in the single currency.
Since the start of the year, the euro recovered more than 12% against the dollar. This is a comeback that we had anticipated by underweighting the dollar which, in our opinion, was playing two incompatible roles: a safe haven for investors who feared the French elections and a more speculative currency for funds that wanted to bet on the American leveraged stock market borrowing in euros or yen to benefit from lower rates. In addition, the Eurodollar rate was too low compared to its theoretical value.
When the exchange rate reached 1.20 – the maximum level we had set ourselves on a short to medium term time horizon – we decided to close the underweight on the dollar by taking profit. And now? For the moment we remain neutral. It seems to us that the ECB does not like a euro-dollar exchange rate above 1.20 and, if it were to go beyond this threshold, it could continue its expansionary monetary policy for longer to mitigate the exchange rate. Furthermore, the Federal Reserve could raise rates again before the end of the year to support the dollar.
Since the beginning of the year, the Italian stock exchange has also recorded a brilliant performance and it performed best in the eurozone despite feared general elections which will probably be held at the beginning of 2018. We believe that there are three main factors that have driven the Italian market; one of these – counterintuitively – is precisely politics.
First of all, there was good economic data. Italy's GDP grew by 0,4% in the second quarter, bringing the annual rate to 1,5%, the highest in the last six years. Growth should continue in the coming quarters, but decelerating due to the strength of the euro and, in 2018, a restrictive budget. A revival of gross fixed investments, a GDP item that has never recovered since the beginning of the crisis, could represent a further engine of growth, but it is difficult to envisage in a context of political uncertainty.
Equally important were the recapitalizations of troubled banks. For the most important groups they were carried out on the markets, for institutions in crisis through the painful involvement of subordinate bondholders and with the intervention of the State. However, an important systemic risk has disappeared, contributing to the return of international investors to the Italian market.
Finally the politics. During the summer there were no major variations in the surveys on the basis of which, with the current rules, a lasting coalition government would hardly be feasible. The specter of ungovernability has therefore not been removed, but the tone towards the euro has considerably lowered: the political movements that were pushing for a referendum (which is not contemplated by the Constitution) seem to have changed their minds on the possibility of leaving the single currency. Overall, this is good news.
