Investors cautiously optimistic on Italy

Indications that a pro-reform government may win the Italian general election boosted risk assets today, though there remains considerable scope for volatility.

Early exit polls signalled that the centre-left coalition led by Pierluigi Bersani's Democratic Party is set to emerge as the largest party in the lower house of parliament, with Silvio Berlusconi's centre-right coalition trailing in second place.

Bersani is broadly supportive of Mario Monti's reform programme, which is why his apparently strong showing is positive for the markets. Monti himself appears to have done poorly, but the most favourable outcome - a Bersani/Monti coalition government - is still possible.

Italy's spreads rallied by 28bps to 222bps after the release of the exit polls, and Italian corporates and banks were among the strongest performers. The overall mood was upbeat, with the Markit iTraxx Europe tightening by 5.5bps to trade at 108bps.

However, Italian politics is rarely simple, and news later in the afternoon suggested that the centre-left may not get everything its own way. Polls indicate that Berlusconi is ahead in the race for the Senate, and the populist Beppe Grillo also appears to have done well.

The news led to credit markets giving back some of their gains and the Italian stock market swiftly went into negative territory. It should be stressed that many Italian political analysts place little faith in exit polls, so it would be a surprise to see conflicting reports over the next 24 hours.

Aside from Italy, the other big story was Moody's decision late on Friday to downgrade the UK's sovereign rating from Aaa to Aa1. This captured lots of headlines, but had a negligible impact on stock and credit markets. The downgrade was more or less priced in and investors are perfectly aware that the UK has a fiat currency and a national central bank.

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