On Sunday the Italians will head to the polls. A year ago this was being hailed as a big risk event for the euro, however heading into the elections the markets have been relatively relaxed about the outcome.
A lot has changed over the course of the year. Politics were particularly unstable after Renzi failed to win a referendum to change the constitution. The Italian banking crisis was in full swing and the fallout from both events was a potential threat to the continuation of the euro project.
However, these fears all turned out to be overdone; the political scene settled down as Renzi resigned and his then foreign minister stepped up to the helm. The economic boom in the eurozone took off, supporting the recovery in Italy and the Italian banks.
The threat:
This weekend the focus is back on Italy. The biggest threat from these elections could come from the 5 Star movement, a Eurosceptic anti-establishment party. Whilst they are unlikely to win sufficient votes to rule alone, there is a small possibility that they could join forces with the Lega Norde, to create an anti-establishment coalition.
This would be a worst-case scenario for the euro, however we consider there to be less than a 10% probability of this happening, given that 5 Star has previously ruled out the possibility of ruling in coalition.
Possible outcomes:
The polls are not showing any clear winner and its also worth noting that Italians can be fickle when it comes to voting. If the economy is doing well, which it is (today GDP came in as expected at 1.6%) then Italians could be tempted to stick with the status quo so as not to rock the boat.
A grande coalition between the Democratic party and Foza Italia (under returning candidate Silvio Berlusconi) would be considered a continuation of current policy. A centre right coalition between Forza Italia, Lega Norde and other right-wing parties such as Brothers of Italy, is another potential outcome.
However, given the parties vastly different perspectives this coalition may not last long. It is worth noting that Italy’s political environment has always been rather chaotic, so a messy election is not going to necessarily create a big reaction in the markets. The markets will be more concerned over threat to the euro project and that is looing unlikely.
Market reaction:
Bond yields are a good way of identifying political risk. Higher yields indicate more fear towards the event. Italian 10 year yields rose to their highest level in 4 months in February. However, this last week has seen the yield drop from a high of 2.171 to 1.985 at the time of writing suggesting investors are not overly concerned heading to the polls.
The euro is only likely to react strongly if the 5 star movement wins an overall majority potentially creating a headache for the euro project. Otherwise, we can expect uncertainties to be played out in the FTSE MIB. The Italian index is down around 7% over the past month.
This is partly thanks to the global selloff in equities, but election uncertainty will also be playing a part. To protect against any political exposition in Italy look towards large cap Italian stocks or those with a strong international reach, for example oil giant ENI.