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Aon Retirement and Investment Blog

AA View: Italian 2018 Elections

For some time we have highlighted how political risk could be a potential cause of an increase in market volatility. The make-up of the next Italian government is one of these risks. Following the election results, which saw a hung parliament with the radical Eurosceptic "five star" movement (M5S) becoming the biggest single party, the prospect that the next Italian prime minister will be from M5S has increased. European markets though were in a sanguine mood this morning. So what is exactly going on?

Market moves
Interpreting market moves is always tricky as it is rare that we can identify exactly what is driving prices. Equity markets had also been worried about the stability of the German coalition government and good news on that may have more than outweighed what has happened in Italy. Italian bank equities have weakened and BTP (Italian government bond) spreads have widened, as reflected in the chart below, but financial markets seem relaxed about the result.

Perhaps more importantly, the result isn't as bad a result as German Chancellor Angela Merkel and French President Emmanuel Macron may have feared. Italian elections have a long blackout period before elections when there are no polls. This means that how support shifted in the final weeks of the campaign is hard to know, even before we consider the difficulties in polling. Consequently, there was a wide spectrum of potential outcomes. The M5S's share of the vote at 32% was at the high end of the likely range but not sufficient to give them outright power. The big surprise was that, although Berlusconi's centre-right coalition's share was in line with expectations, the composition of votes within the coalition was very different. Berlusconi's own Forza Italia party underperformed, getting only 14% of the votes, but the Northern League (NL) managed 18%. The centre-left's coalition's collapse to 23.5% certainly wasn't unexpected given the low approval ratings of the government led by the Democratic Party (PD).

So why aren't markets worried by what seems to be a collapse in the Italian establishment parties?

  • Firstly, expectations were already low. Some form of coalition was always likely and the chances of any coalition delivering the kind of structural reforms Italy needs to return to long-term growth were low.
  • Secondly, the danger isn't in the exact vote shares but what will evolve in terms of horse trading over the next few weeks. Most political experts think that M5S and NL are sufficiently ideologically opposed on non-European Union issues that they will not form a coalition, at least without the mollifying effect of other parties joining them.
  • Thirdly, M5S has toned down its eurosceptic stance in recent months. Whilst the leadership is critical of the single currency, polls of M5S supporters suggest that they support staying in the Eurozone.
So what will happen now?
It seems unlikely that a coalition will be formed quickly. Matteo Renzi's resignation as leader of the previously ruling PD (he resigned as PM back in 2016 after losing a referendum on constitutional reform) clears the way for other parties to be more inclined do a deal with them. Some role for PD in the coalition is the best chance of continued economic reforms of the banking system, which despite a focus on cleaning up balance sheets over the last two years, remains burdened by high levels of non-performing assets. A PD-M5S deal is possible although some analysts think that it could essentially finish off PD in the same way that the UK's Liberal Democrats were hurt by being the junior coalition partner in the UK over 2010-2015.

Prior to the election some analysts highlighted the possibility of a "grand coalition" of the centre-left and centre-right coalitions. Now that M5S has a third of the seats this seems less likely now, but it is possible that a grand coalition with M5S could be built. This would likely see the defections of some M5S members but the more moderate members might be prepared to work with other parties if that meant their candidate, Luigi Di Maio, became PM. On 23rd March the Italian Parliament will re-convene. The process of electing the Presidents of the two Houses will give clues about who is working with whom and we should start to get a better feel for how things might pan out. However, the process is unlikely to be quick. All the parties, particularly those in the centre-right coalition, made fiscal promises which were unrealistic. Whilst being able to blame other coalition partners provides some cover, the coalition government will likely remain an unpopular one, and parties may play the long game and try to stay in opposition. We don't think a government will be formed until we are well into April.

What does it mean for markets?
Markets are putting only a tiny probability on a break-up of the single currency in the next decade and this result it unlikely to change that. Having a M5S prime minister might cause further Italian-German bond spread widening but we doubt that, by itself, it will have significant impacts outside Italy. The only scenario where we think there could be an adverse impact on the rest of the periphery is if M5S and NL might put their differences aside and form a government on their own. With two eurosceptic parties in charge, a referendum on membership of the single currency would be likely. Even if "remain" was to eventually win, the referendum itself would likely be extremely disruptive. We would expect an adverse reaction across European equity markets, peripheral bond markets, and weakness in the euro itself.

For Europe to go wrong we think that there will need to be more than just a Eurosceptic coalition in Italy. The danger is more if we had a perfect storm of adverse political shocks: a collapse in the German coalition followed by elections where the Alternative for Deutschland make further gains; renewed vigour from Catalonia for independence from Spain; and a Melenchon or Le Pen like figure replacing Macron in France. For all of these to happen might seem improbable but they're not independent risks. With the European economy recovering strongly and French elections a long way off, we don't see a perfect storm imminently but political risk in the Eurozone remains.

Derry Pickford is a Principal on Aon Hewitt’s Global Asset Allocation team, and is based in London, UK.

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