The two political sagas in Italy and Spain came to an end after Italy?s populist parties cobbled together a new government to end a three-month impasse while Spanish Prime Minister Mariano Rajoy was ousted. However, while we believe the concerns that had rocked markets will continue to persist, now is not time to exit equities and recommend staying invested and manage risk.

Defusing near-term Italian and Spanish political risks does not necessary offer a clear path higher for the euro and European markets in general if in the coming months;

  • The new Italian government implements an unworkable fiscal program putting the country further into debt, harming economic confidence and thereby undermining relations with the European Union.
  • Newly installed Spanish Prime Minister Pedro Sanchez starts making large changes and does not maintain the reforms put in place by the previous government that is keeping Spain on a trajectory of improving economic growth.

We don?t think incrementally what has happened in the last couple of weeks is going to change the Italian economic outlook as bank lending has not increased and the economy continues to be one of the laggards of Europe. This follows our recent cut to our 2018 Eurozone GDP growth forecasts from 2.5% to 2.2% due to rising oil prices and weaker manufacturing growth in May as the strength of export demand eased.

While we believe the euro is undervalued versus the USD based on long-term fundamentals on a 12-month view, for the moment the euro is coming against some headwinds as uncertainly about the political and economic outlook in the Eurozone remains along with high oil prices despite falling in the last few days. If businesses have to pay US$20 more for a barrel of oil means businesses have to spend US$20 more which will be a support for the USD. Longer term, the USD will weaken as the current account deficit becomes larger. Our three-month EURUSD forecast is 1.20 and our six-month EURUSD forecast is 1.25.

The market reaction confirms our view that investors should expect greater volatility this year than last. Overall, while we must not get complacent about political risk in Italy and Spain, barriers to anti-euro proposals becoming government policy remain. While we do not see major obstacles for European economic growth or the euro, we will continue to monitor the situation and react accordingly.

HXL Partners

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