Italian Elections: A Wild Card for European Markets
- The outcome of Italy’s general election on March 4 could make or break its economic recovery – and jeopardize or solidify its place in the European Union.
- While there is no clear front-runner, a candidate with the newly formed Five Star Movement currently leads the polls.
- The consensus view is for a market-friendly outcome, but the market may be underestimating the tail risk of a surprise result or, perhaps worst, ongoing uncertainty.
Italy’s March 4 general election is noteworthy for many reasons – and not just because ousted prime minister Silvio Berlusconi is back in politics or because the current front-runner represents the Five Star Movement, started by a popular comedian with a populist agenda.
The outcome will ultimately determine whether Italy will continue to implement necessary fiscal reforms or, conversely, favor populist programs that could derail those efforts, and at a time when the European Central Bank is gearing up to reduce its stimulus.
Janus Henderson Portfolio Manager Barrington Pitt Miller and Financials Analyst Iacopo Dalu offer insight into why Italy’s elections matter and what investors might expect in the months ahead.
Why is Italy’s upcoming election notable?
Iacopo Dalu: Italy is the Eurozone’s third largest economy (after Brexit), and with the exception of Greece, it is Europe’s most indebted country. Meanwhile, this is the last major election we’ll see in Europe for a while, and it’s on the heels of Brexit and the Catalonia situation.
The bigger issue, however, are concerns about Italy’s financial system, which is widely considered a weak link for all of Europe. The outcome of the election is likely to determine whether the government continues on the path of reforms, and ultimately whether Italy will remain in the European Union.
Failure to adhere to structural reform and render the Italian debt burden sustainable can leave markets to once again try to force Italy’s fate. The European crisis peaked here. Were it to resurface, this is likely to be the source.
How is Italy’s electoral system unique?
Dalu: Italy’s electoral system most resembles that of Germany, but there is really nothing like it. In order for a party to take control of the parliament, it will likely require securing close to 40% of the popular vote. If it falls short, the party has to form a coalition with other parties. Yet, no party will announce a national coalition until after the vote for fear of alienating voters opposed to the potential partner. In other words, even following the election, there is likely to be ongoing uncertainty about who will govern Italy, and how.
What is the backdrop for Italy’s economy?
Dalu: GDP growth is still low in absolute terms, with about 2.5% nominal growth, but that is an improvement relative to where Italy has been. That said, there are still big problems, namely Italy’s debt to GDP hasn’t been this high, at 132%, since the period following World War I.
Barrington Pitt Miller: The combination of high debt and tepid growth is the reason the Italy story is critical to EU stabilization. For now, growth is sound and sovereign yields are low, but the debt dynamics are still in a fairly precarious situation, and if you have the wrong government – or even the perception of the wrong government – confidence can erode pretty quickly.
Who are the current frontrunners?
Pitt Miller: If you look at the polls right now, no single party or predictable coalition has enough support to form a government. But the Five Star Movement, an anti-establishment party formed in 2009, was recently leading the polls, at about 28%. The party was initially pushing to leave the euro but has recently softened its position.
If they win, the real question is what kind of coalition they will form. We think it’s improbable, but there is a risk that they would align with League (formerly Lega Nord), creating a party that is anti-Europe and anti-immigration. We view this as the worst market outcome, and a deeply negative European event.
How are other parties are polling?
Dalu: On the center-left side the main party is the Democratic Party, but they have lost a lot of support in the polls; they were recently in the low to mid 20s, and those numbers have been in constant decline.
On the center-right, you have Berlusconi’s Forza Italia, which was recently polling around 15% to 18%. Putting Forza Italia with League and other right-wing smaller parties would form a traditional coalition. If they don’t form a majority (they’re polling close, but short of 40%), we expect Berlusconi and some center-right moderates to create a grand coalition that could include some center-left parties. We think this is the most likely outcome and, in our opinion, probably the most positive for the market.
What has been the market’s reaction?
Pitt Miller: Italian sovereign yields initially underperformed versus German Bunds after Prime Minister Paolo Gentiloni’s cabinet set the date for the election. However, global market sentiment has since lifted Italian equities and unwound the late December spread widening. Nonetheless, the Italian-Bund spread, recently 128 basis points, is almost twice as wide as Spain’s.
Bottom line: We believe there is a two-thirds probability that the outcome of the election is market friendly and a one-third probability that it is not, though this could change quickly if one party pulls ahead in the polls.
That said, we don’t think markets are pricing for the tail risk of a Five Star and League coalition, or what is likely to be an extended period of uncertainty – not just about who will govern but how they will govern.