In just a few days, investors have shifted from perhaps excessive complacency to excess pessimism about Italian politics. Volatility is likely to remain for some time, as Italy is entering into unknown territory in terms of governance, which is perhaps worth a specific political risk premium. However, even if a serious confrontation is inevitable between the new government and the European institutions (on immigration, fiscal policy and foreign policy), we do not expect an imminent default risk or euro exit. Weaknesses in the Italian economy are well identified (public debt, very low potential growth, low productivity), but the economic situation has improved significantly in recent years. As long as monetary and financial conditions remain accommodative, the recovery in Italy should continue.

In just a few days, investors have shifted from excess complacency just before the turmoil (MIB index up 10% since the beginning of the year, stable sovereign spread despite the uncertainty concerning the government) to excess pessimism (fall in the stock market, surge in sovereign spreads to their highest levels since 2013); the shock was even more pronounced on short-term interest rates than on long-term rates. This implicitly means that investors were beginning to price – with a significant probability – a break-up of the Eurozone (Italexit) and as a result a sovereign default …