Are the financial markets reading the signs correctly, with this latest election generating yet another prolonged, predictable struggle for a coalition? Or will one of the opposition parties upend Italian politics?
Italy’s election has generated much conversation among political analysts this year – as well as a relatively muted reaction from financial markets. Year to date, during the week’s run-up to election day on Sunday, March 4, 5-year Italian sovereigns are trading at1 0.727%, notably below their December 8, 2017 high of 0.781%; the FTSE MIB Index is up 3.99% year to date after bouncing off its February 13 low.
Are the financial markets reading the signs correctly, with this latest election generating yet another prolonged, predictable struggle for a coalition? Or will one of the opposition parties upend Italian politics, and therefore the delicate balance between Italy and the rest of the EU?
Read on to discover points of view from Legg Mason’s independent-minded investment experts:
Head of Global Value
As the March 4th Italian election approaches, it appears that investors are somewhat complacent about the outcome. Put-call spreads on euro options are far from the levels experienced in last April’s French first-round elections. Italian 10-year bond rates have risen by 20 basis points over the past three months — less than the 29-basis-point rise in German bunds. Markets are prepared for an uncertain result, but one that does not threaten the building eurozone economic recovery or the single currency.
While we also see a hung parliament and continuation of the caretaker government as the most likely result, there is a good chance of a more disruptive scenario emerging. Basically, the main battle is between a resurrected Silvio Berlusconi and his right-wing coalition and the anti-establishment Five Star Movement led by the 31-year-old Luigi Di Maio. Both are tapping into the fear and anger over Brussels-imposed austerity and immigration. In the past decade, an estimated 1.5 million Italians have moved abroad due to nearly 20 years of economic stagnation. At the same time roughly 600,000 immigrants have poured into the country, mostly from Northern Africa, and are forced to stay in Italy due to European Union (EU) law. Combined with youth unemployment of 33%, this has caused a move away from the traditional center-left political parties, namely Mateo Renzi’s Democratic Party.
Berlusconi needs to capture at least 40% of the seats in parliament to form a government but even then, the infighting between the far-right and more centrist members of his coalition could prove problematic. This could be an impediment to passing needed structural reforms and deficit levels would likely rise although Italy would remain in the single currency market.
The largest single block on course to win seats is the Five Star Movement, which is beginning to back away from its original “no coalition” stance. The challenge is that Mr. Di Maio still wants to be PM and is offering no ministerial seats in return for joining his voting bloc. If he abandons these unworkable preconditions and wins a large proportion of the vote, then a partnership with the Northern League is possible. This would be highly destabilizing to the markets since both groups are historically anti-eurozone.
Another potential outcome would be a grand coalition of the Forza Italia and Democratic parties as Berlusconi and Renzi adopt a pragmatic stance. In a recent press interview, Mr. Renzi left the door open for such a compromise, even hinting that he would not have to return as prime minister. Berlusconi, barred from serving in government due to his tax fraud conviction, would act as “kingmaker” and appoint a center-right PM. This outcome is probably the most favorable to equity and bond markets in the short term.
Regardless of the specific election outcome, ranging from caretaker to right-wing “Italexit,” we are concerned that a populist platform of higher government spending, lower taxes and increased confrontation with the EU is likely. In the context of a more receptive and economically healthy Europe, this is more of a threat to bonds than equities in the short run.
We think the market is suffering from ‘election fatigue’ ahead of Italy’s crucial vote on Sunday. 2017 was a big year for election risk in Europe. Following the UK’s surprise vote to leave the EU and Trump's election victory in 2016, the market raised the populist risk premium ahead of the Dutch and French elections in 2017.
In electing Emmanuel Macron the French electorate clearly rejected populist momentum and voted for more, not less, Europe. This was an important factor that led us to add to Italian sovereign and credit risk and move overweight the euro currency in 2017. Therefore, for Sunday’s vote to destabilize the European convergence trade we need to see an anti-EU party win the election.
This can happen in two ways but both outcomes appear equally improbable:
- The Five Star Movement (M5S) could win an outright majority. Recent polls see M5S polling 27%, 13% short of the 40% that most political pundits think is required to gain an outright majority
- The second possibility would be a centre-right coalition led by the Northern League’s (NL) Matteo Salvini who has made his objections to closer European integration very public. For this to happen the centre-right coalition would need to win 40% of the vote share and NL win more votes than Silvio Berlusconi’s Forza Italia (FI). This too appears unlikely with the centre-right coalition polling 35% of the vote and with FI 3% ahead of NL
Therefore, it is very unlikely we get an outcome that sees Italy led by an anti-EU party; hence the likelihood the European convergence trade is derailed at this event is very small.
A bigger risk is the vote on Sunday that is taking place in Germany. Members of Germany’s SPD party will decide whether they want to join a Euro-friendly grand coalition with Angela Merkel’s CDU party. Only a slim majority of SPD members want to join Merkel so a rejection of the coalition will result in new elections or a minority government. In our opinion the most market unfriendly outcome on Sunday would be a very strong result for the anti-establishment Five Star movement and the SPD members voting not to join Merkel’s coalition. In this scenario we would expect the Italian 10yr spread to Germany to widen past 150bps.
The most likely (and market friendly) outcome on Sunday is a pro-coalition SPD vote and a hung parliament in Italy. In the case of an Italian hung parliament the focus will be on whether the centrist mainstream parties win enough seats to form a grand coalition. Importantly we think this market friendly outcome is almost fully priced into Italian bonds with the 10yr spread at 135bps over Germany. We have not been constructive on Italy and go into Sunday’s election with a neutral opinion.
If a grand coalition is not a viable option then we may enter a prolonged period of uncertainty and possibly new elections but remember during this period the Gentiloni government would remain in place thus ensuring continuity of government and stability. With the most positive election outcome priced into markets we see little reason to go into the election aggressively positive.
In the longer term, spreads will be determined by the cyclical and secular growth outlook for Italy. Growth has surprised to the upside as global growth has proved resilient. To meaningfully boost potential growth in Italy which will help reduce the debt burden Italy needs deep structural reform.
Will any of the possible electoral outcomes on Monday morning produce a government with the mandate to make the tough decisions required? We think not. Does this mean Italian debt is unsustainable in the long-run? No because Italy has proven time and time again it can make tough decisions when pushed. Are wider spreads required as a catalyst for change? Possibly.
1 Source: Bloomberg, Feb 27 2018, 1:00 PM ET