Italian Elections: Which Scenario Is Best for Markets?

2018/02/06
Italian Elections: Which Scenario Is Best for Markets?

Summary

Elections in Italy can be notoriously hard to predict, but the most likely outcomes are a new government from the current centre-right coalition or a new PD/centre-right coalition. The markets should absorb either event in stride; even if bond spreads widen, we believe Italy is still a buy as long as the centre holds.

Key takeaways

  • Italy’s new electoral law favours established political forces that can form larger coalitions
  • Some of the policy ideas of the Italian centre-right coalition worry the markets, since they could increase the country’s already-high debt-to-GDP ratio of more than 130 per cent
  • It appears very unlikely that Italy’s more extreme parties, including the Five Star Movement, will win – good news for the markets, which would soundly reject their economic and political proposals
  • Italy’s BTPs are currently relatively expensive, but even if spreads widen before or after the elections, we believe Italy is still a buy as long as its most extreme parties don’t emerge victorious

Italy’s general elections on 4 March will likely be the biggest political event in the euro zone this year. Voters will elect a new parliament and the governors of Lombardy and Lazio – two important regions that represent one-third of Italy’s GDP.

New Electoral Law Favours Establishment Coalitions

This will be the first time that Italy’s new electoral law, passed in October 2017, will be tested. The law helps established political forces that can form larger coalitions – such as the centre-left or centre-right alliances – rather than the Five Star Movement (M5S) or other anti-establishment forces that are unwilling to share power with others.

Yet according to the most recent polls, none of the proposed coalitions appears able to reach the 40 per cent share of total votes needed to gain control of the lower house and form a government:

  • The centre-left coalition currently in power has seen a steady drop in its approval ratings.
  • The M5S appears likely to win the most votes, but should be unable to form a government.
  • The centre-left coalition is on track to suffer more abstentions than its centre-right counterpart. If this holds, the centre-right may win control of the lower house.

Four Scenarios

With the important caveat that electoral polls are not highly reliable instruments, here are four potential outcomes for Italy’s elections.

Least likely: Markets get their preferred centre-left coalition

There appears to be little chance that the centre-left coalition that currently controls the government – led by Prime Minister Paolo Gentiloni – will survive the elections intact. This coalition would have been the markets’ preference, since it is considered more disciplined in managing fiscal policy. Italy’s worrisome debt-to-GDP ratio of more than 130 per cent is the second-largest in the euro zone, after Greece.

Increasingly possible: Centre-right emerges the clear winner

If the election crowns a single clear winner, we expect it to be the centre-right coalition. This would be slightly less favourable for the markets, but not too negative. Under this scenario, the new prime minister would likely be a moderate, pro-Europe figure – probably not too different from Mr Gentiloni himself. One of the potential candidates is Antonio Tajani, the current president of the European Parliament.

Most likely: No clear winners, but PD/centre-right come together

A lack of clarity is the most likely election outcome. If this holds, we expect to see a coalition government formed by the Democratic Party (PD) and parts of the centre-right electoral alliance, with Mr Gentiloni remaining in power until the parties reach a new agreement. If those discussions get drawn out, the markets may feel an impact, but we don’t expect to see a large sell-off while Italy’s economy continues to improve.

Tail risk: Outside parties coalesce

There is a remote possibility that Italy’s non-mainstream forces – M5S, Northern League and Extreme Left – could form a coalition, yet the political DNA of these parties seems impossible to combine. M5S and Extreme Left do share a similar ideological space and could combine forces, but their economic and political platform would be soundly rejected by the markets. Fortunately, this possibility seems very unlikely.

Investment Implications

If the ultimate outcome of this election is a PD/centre-right coalition that coalesces quickly, the spread on Italian debt has the potential to tighten sharply as investor confidence improves. The markets increasingly look to the euro-zone periphery to demonstrate the kind of cyclical-recovery story that leads to a positive reassessment of credit ratings; this already happened in Portugal and Spain, and it could happen in Italy as well.

If the election results in a centre-right coalition, which is not our most likely scenario, the investment picture would be mixed. We wouldn’t expect to see a negative impact on the spread between German and Italian government bonds, but the markets would need to learn more about the new government’s economic program. Reactions could be severe if the centre-right were to implement its proposed ideas: a decrease in the corporate tax, an increase in minimum pension levels and a flat income tax could all increase Italy’s debt.

The bottom line is that Italy’s treasury bonds (BTPs) are currently relatively expensive, with spreads of 127 basis points over German bunds as at 1 February. In the run-up to the elections, we may see signs of nervousness as BTP-bund spreads move back towards 145 to 150 basis points, or even beyond. If there are no clear winners after the election, we could see wider spreads if an agreement between PD and Forza Italia takes time to materialize. In the meantime, the break-up of the centre-right coalition would force the Northern League to increase the anti-euro message it has so far toned down. But even if spreads widen before or after the elections, we believe Italy has attractive investment opportunities.

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Italy Election Results: Focus on the Fundamentals

2018/03/05

Summary

While the strong showing of the anti-establishment Five Star Movement was the story of the night, the initial results of Italy’s election indicate a hung parliament. The question for investors is whether the political uncertainty will overshadow the country’s improving economic fundamentals.


Key takeaways

  • M5S looks set to be a driving force in any new government, but markets may doubt the fiscal sustainability of some of its policies
  • Some short-term volatility is likely to ensue, as markets had outperformed in expectation of a grand coalition between PD and FI
  • Politicians shouldn’t waste the opportunities that the current phase of synchronised global growth offers Italy