Italy’s general election this weekend is arguably the most important political event in Europe this year, in what otherwise looks like a relatively quiet calendar. With voter support fairly evenly distributed among three political factions ‒ the centre-right, led by Forza Italia and the Northern League; the centre-left, led by the Democratic Party; and the anti-establishment Five Star Movement ‒ chances that the election on 4 March will deliver a strong reform-oriented government look slim.
While this doesn’t bode well for a sovereign with a high debt burden and in significant need of reform, the formation of a weak government is not a huge concern for the financial markets, which are cheered by the ongoing cyclical upswing in Europe and not as focused on medium-term issues. What markets seem to care about most is that a “near-term accident” is avoided. In the context of this election, such an accident would probably be the formation of an anti-establishment government built on a euroskeptic platform.
Tail risk and more likely outcomes
We cannot entirely rule out an “accident” outcome, but we would view it as a tail risk only. An anti-establishment government could possibly arise from a post-election alliance among the Five Star Movement (M5S), the Northern League (NL) and perhaps the far-right Brothers of Italy (BoI) party.
However, this scenario seems unlikely for several reasons. First, the latest polls suggest that these parties will not gather enough votes to have an absolute majority of seats. Second, the parties tend to appeal to different voter bases (NL to voters who are from the north and right-wing, M5S to voters who are from the south and those of heterogeneous ideologies). And third, M5S has been moving away from its euroskeptic stance lately.
More likely, a moderate government will be formed, led by the centre-right (if it gathers enough votes) or by the centre-right or centre-left in a grand coalition setting. Another possibility is that no agreement is struck, and new elections are eventually called. Investors are likely to perceive a moderate government of some kind as positive, new elections as neutral to slightly negative, and a euroskeptic alliance as clearly negative.
Post-election scenarios and outlook
So, how do investors navigate the Italian election? We see three possible scenarios:
- Centre-right coalition gets an absolute majority. Government formation in this case is likely to be quick. Forza Italia will likely be the leading party, and have the choice of prime minister. Italian government bond (BTP) spreads should tighten following this outcome.
- No winner, with results broadly in line with latest polls (the most likely scenario). The centre-right coalition performs well, but is short of an absolute majority of seats; the Democratic Party and Five Star Movement lag, with Five Star capped at 30% or so of the votes. Government negotiations could be prolonged but would likely end up in a grand coalition government led by Forza Italia/the Democratic Party and supported by members of parliament from other parties/coalitions. Market volatility could remain high during negotiations given the uncertainty, but the eventual government agreement should lead to some tightening in BTP spreads. If no agreement is found and new elections are needed, spreads could remain wider for some time.
- No winner, with M5S doing very well. In this scenario, M5S gets more than 35% of the votes. A euroskeptic alliance would remain difficult to forge, but markets would romance this possibility. Luigi Di Maio, head of M5S, might be given an “exploratory mandate” to form a government, which might fail but could spook the markets. BTP spreads would almost certainly widen on this outcome. The likely failure of M5S to form a government could eventually lead to a tightening in spreads, unless a euroskeptic alliance is formed between M5S/NL/BoI (our tail-risk scenario).
While bouts of volatility are possible if Italy does not manage to form a government soon after the election, looking over the next six to 12 months, we think BTP spreads will be anchored in most scenarios.
We are fairly neutral on BTPs at current levels, a position that reflects our outlook for a balance between good cyclical conditions/limited political risk and medium-term concerns about the eurozone infrastructure.
For more, please see “Eurozone Outlook: Economic Growth Masks Underlying Fragility.”
Nicola Mai is a PIMCO portfolio manager and leads sovereign credit research in Europe.