Italian Election: Domestic Financial Market Stress Possible
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Italian Election: Domestic Financial Market Stress Possible

The Italian election results could weigh on domestic market sentiment in the short term. Pullbacks in the Euro should be used as a buying opportunity. 

Italy went to the polls on 4 March, in what some investors believed to be the most important political event for Europe in 2018. According to the preliminary results available at the time of writing, the Five Star Party (M5S) performed much better than expected, securing around 32 percent of vote, according to the preliminary vote count. Their strong showing came at the expense of the center-left coalition, which disappointed at around 24 percent of the vote. Meanwhile, the center-right performed as expected (37 percent) although within this bloc the Eurosceptic League surged at the national level, at about 18 percent of the vote, and outpolled Silvio Berlusconi’s Forza Italia.

No Major Risk for the Eurozone

In line with our expectations, the ballot has resulted in a fragmented parliament, with no outright majority for any one party or coalition. The most likely outcome of the current vote distribution is thus a broad coalition. The government formation could entail a prolonged period of uncertainty as likely inconclusive single party negotiations risk preoccupying parties for some time. Financial market uncertainty will also be higher given the mathematical majority for the two extremists parties, even if an alliance between the M5S and the Eurosceptic League remains unlikely for the time being given their significant political divergences.

In the coming weeks, Italian President Sergio Mattarella is expected to start a consultation process with the party heads. Domestic market sentiment could be subject to volatility as political discussions intensify, although risks should be contained to the domestic market. We see no major risk for the Eurozone or of Italy leaving the currency bloc.

Fiscal Stance in the Spotlight

The good showing of the M5S party, which confirmed its position as the largest political force, and the strong gains of the Eurosceptic League will leave the debate on populism and immigration-related issues wide open. Election manifestos put an emphasis on a larger fiscal deficit via additional public spending, which will likely remain topical going forward. Deep structural reforms are unlikely to be part of the next government’s agenda given the populist tone of the election. Yet we could even see a risk of a minor unwinding of reforms depending on the final government formation.

Short-term Volatility Can Be Expected

Overall, the results have had a mild negative market impact in the first trading hours. The EUR is moderately weaker, Italian BTP bond futures are lower, with 10-year cash yields pushing back toward 2 percent. Italian equities have also opened lower. Markets have largely adopted a cautious stance regarding the risks related to Italy, but not sold off aggressively given the backstop provided by the European Central Bank (ECB) and the upturn in macroeconomic activity. Italian Treasury bonds could nonetheless further underperform if the market takes a less optimistic view on Italy’s commitment to reforms and if looser fiscal discipline ensues. Given that Italian stocks have performed well so far this year, we feel that we are unlikely to see further outperformance.

Looking ahead, short-term volatility can be expected as political discussions get under way, but the cyclical upswing in Europe should continue to provide a tailwind for our risk-on stance and our positive view on both global and European equities. In addition, the expected normalization in both inflation and the ECB’s extraordinary monetary policy should help to take the EUR/USD towards our forecasts of 1.26 and 1.30 over 3 months and 12 months, respectively. Accordingly, we would see any pullback in the common currency related to a potential pick-up in Italian policy uncertainty over the coming days as an opportunity to add exposure to the EUR.