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The cost of hedging against a disaster scenario in Italy’s government debt market has fallen sharply since the French elections, as Italy looks to the example set by its northern neighbor. As Asia Unhedged reported last week, Italian analysts see reduced risk of an anti-EU populist government, and a gradual resolution of Italy’s banking mess.
Italy has $2.2 trillion in government debt, equal to more than 100% of GDP, the same amount as Germany on top of an economy half the size. Investors worry that Italy might try to get out of its debt problems by leaving the Eurozone and repaying the debt in a cheaper national currency. Credit default swaps hedge that risk, and the price of the hedge has come off sharply since late March. Under the best of assumptions Italy faces a long and difficult path of reform and restructuring.
In the meantime, the reduced risk of an Italian debt crisis is great news for other European stock markets. With Germany’s economy expanding smartly and France following, European equity valuations are attractive relative to the United States and Japan–provided that Europe avoids a new financial crisis. Confidence that Italy is less likely to explode helps explain today’s strong gains in northern European markets.