Italian election: will markets avoid the nightmare scenario?

Will the March 4th Italian general election deliver another dramatic populist uprising to shake markets or will a centrist coalition calm investor jitters? Unfortunately for investors, the results of the Italian elections are acutely difficult to predict, as a new electoral law will be applied for the first time and the accuracy of polls has been undermined since Brexit.

In the following insight, Fabrizio Quirighetti, co-head of multi-asset at SYZ Asset Management, disentangles the political complexity by discussing the possible scenarios and potential implications for financial markets.

Nightmare scenario unlikely

Let’s start with the good news. A victory for Luigi di Maio, the designated candidate for the Five Star party (M5S) – undoubtedly the worst-case scenario for equity markets, Italian bonds, and the single currency – seems highly improbable.

This is principally because his party does not want to form an alliance with its counterparts. And the feeling is mutual: the other parties do not want to band together with Five Star either. Not only does di Maio lack 7-10% of the national vote, but, moreover, the centre-right is likely to grab the majority of districts.

Even with a victory for the M5S party, a minority government led by M5S has very little chance of seeing the light of day, as the current electoral system favours coalitions – which would likely lead the president of the Republic to mandate a representative of the leading coalition (centre-right) rather than the leading party.

We also dismiss the scenario of an anti-establishment government (M5S, FI and LN). While possible in theory, given the gains achieved by each of these parties, in practice, there is a great deal of dissension between each party. Moreover, reconciliation would lead to a loss of popular support, as it would go against the very principles of M5S and its successful standpoint: “neither right, nor left”.

‘Small majority’ would create longer-term difficulties

According to the latest polls, a centre-right coalition is not far from obtaining a majority – it lacks between 20 and 50 seats. In the event this shortfall drops to less than 20 seats, it could lead to the crossover of some “centrist” parliamentarians from the left wing or desertion in other minor parties.

This “small” majority would lead only to a small increase in Italian equities, as well as a reduction in the spread between Italian and German bonds and a slight increase in the euro in the short term. This is because a small majority would lead to longer-term instability.

We expect this scenario would increase tensions linked to the possibility of further elections in the next 6-12 months. Beyond the positive impact of the news in the short term, a new uncertainty would very quickly arise: the appointment of the new prime minister within this centre-right coalition.

Silvio Berlusconi cannot take this on because he is ineligible, as a result of legal proceedings in the past, but it is still he who calls the shots within his party; Matteo Salvini and Lega Nord, have hinted at the desire to fulfil the role. The internal power struggle could be a long and bitter one. The stability of this outcome is fragile.

While Salvini’s appointment at the head of the government would undoubtedly wipe out the positive reaction of markets, an appointment from within the Forza Italia party would not guarantee an enthusiastic response from investors either. Particularly as the current prime minister, Paolo Gentiloni, who will continue at the helm during the transition period, is popular with investors.

A “narrow” defeat would not change much in terms of the scenario described above, apart from the following: markets would not react strongly in the short term and there would be less volatility in the medium term, because the current prime minister will retain his mandate; there would also be fewer destructive internal power struggles and alliances within the centre-right coalition.

Coalition of centrists: a new hope

There is a possibility none of the parties or coalitions obtain a clear majority. We would most likely see a slight negative reaction from markets in the first instance, but not a sense of panic, since on the one hand Paolo Gentiloni would remain at the helm and, ultimately, if the centre-right and centre-left parties join forces, that would certainly be the best possible scenario.

If the far-right parties, and the far-left parties to a lesser extent, were abandoned or marginalised, this would lead to a new wave of hope, similar to that witnessed after the victory of Emmanuel Macron’s party in France. Here, too, we have to count on the crossover of some parliamentarians to ensure the majority. And here, too, a large coalition does not necessarily mean a strong and cohesive one.

For the moment, the centre-right coalition seems to be the most likely outcome, but the possibility of a large coalition could very quickly become a real probability, if the scores obtained by the far-right parties turn out to be lower than expected.

‘Better ungoverned than badly governed’

If it proves impossible to form a government, there will be further elections held 6-12 months from now. The negative impact will be marginal and short-lived. The draft budget will be affected, but ultimately, would it be such a great surprise if Italy, which has had 62 governments since the end of World War 2, does not have a proper government in place for a few months? Did Belgium or Spain, which have seen similar situations in the past, come out worse for wear? Maybe sometimes it’s better to be ungoverned than badly governed.

More than any other major eurozone country, Italy needs to put structural reforms in place to try and dilute, as quickly as possible, its dangerous cocktail of low growth and booming public debt. But most Italians are not fooled, since the worst-case scenario in terms of an explosion of public debt, namely a unilateral victory by Lega Nord, Liberi e Uguali, or the Five Star Movement, is not foreseeable.

For the rest of the players, the PD (Matteo Renzi’s Democratic Party) plans to maintain the status quo in terms of fiscal policy, and the impact of the Forza Italia plan is still difficult to evaluate, as they promise significant tax reductions and a desire to reduce the public debt ratio to 110% in the next five years. We can dream, but Italians do not believe these measures will be implemented any time soon. Unless the winds of change one day blow over Italian politics, like they did in France.

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