Italy’s general elections on 4 March will likely be the biggest political event in the euro zone this year. They can be notoriously hard to predict, but the most likely outcomes are a new government from the current centre-right coalition or a new PD/centre-right coalition. The markets should absorb either event in stride; even if bond spreads widen, Allianz Global Investors believe Italy is still a buy as long as the centre holds.
This will be the first time that Italy’s new electoral law, passed in October 2017, will be tested. The law helps established political forces that can form larger coalitions – such as the centre-left or centre-right alliances – rather than the Five Star Movement (M5S) or other anti-establishment forces that are unwilling to share power with others.
Yet according to the most recent polls, none of the proposed coalitions appears able to reach the 40 per cent share of total votes needed to gain control of the lower house and form a government. With the important caveat that electoral polls are not highly reliable instruments, strategists from Allianz Global Investors provide with four potential outcomes for Italy’s elections.
Least likely: Markets get their preferred centre-left coalition .
There appears to be little chance that the centre-left coalition that currently controls the government-led by Prime Minister Paolo Gentiloni – will survive the elections intact. According to analysts at the house this coalition would have been “the markets’ preference”.
It is considered more disciplined in managing fiscal policy. Italy’s worrisome debt-to-GDP ratio of more than 130 per cent is the second-largest in the euro zone, after Greece.
Increasingly possible: Centre-right emerges the clear winner.
If the election crowns a single clear winner, analysts expect it to be the centre-right coalition.
This would be slightly less favourable for the markets, but not too negative. Under this scenario, the new prime minister would likely be a moderate, pro-Europe figure – probably not too different from Mr Gentiloni himself. One of the potential candidates is Antonio Tajani, the current president of the European Parliament.
Most likely: No clear winners, but PD/centre-right come together
A lack of clarity is the most likely election outcome: a coalition government formed by the Democratic Party (PD) and parts of the centre-right electoral alliance, with Mr Gentiloni remaining in power until the parties reach a new agreement.
If those discussions get drawn out, the markets may feel an impact, but we don’t expect to see a large sell-off while Italy’s economy continues to improve.
Tail risk: Outside parties coalesce
There is a remote possibility that Italy’s non-mainstream forces – M5S, Northern League and Extreme Left – could form a coalition, yet the political DNA of these parties seems impossible to combine. M5S and Extreme Left do share a similar ideological space and could combine forces, but their economic and political platform would be soundly rejected by the markets. Fortunately, this possibility seems very unlikely.
If the ultimate outcome of this election is a PD/centre-right coalition that coalesces quickly, the spread on Italian debt has the potential to tighten sharply as investor confidence improves.
In Allianz Global Investors’ opinion:
The markets increasingly look to the euro-zone periphery to demonstrate the kind of cyclical-recovery story that leads to a positive reassessment of credit ratings; this already happened in Portugal and Spain, and it could happen in Italy as well.
If the election results in a centre-right coalition, which is not our most likely scenario, the investment picture would be mixed.
We wouldn’t expect to see a negative impact on the spread between German and Italian government bonds, but the markets would need to learn more about the new government’s economic program. Reactions could be severe if the centre-right were to implement its proposed ideas: a decrease in the corporate tax, an increase in minimum pension levels and a flat income tax could all increase Italy’s debt.
The bottom line is that Italy’s treasury bonds (BTPs) are currently relatively expensive, with spreads of 127 basis points over German bunds as at 1 February. In the run-up to the elections, the experts may see signs of nervousness as BTP-bund spreads move back towards 145 to 150 basis points, or even beyond.
If there are no clear winners after the election, we could see wider spreads if an agreement between PD and Forza Italia takes time to materialize. In the meantime, the break-up of the centre-right coalition would force the Northern League to increase the anti-euro message it has so far toned down. But even if spreads widen before or after the elections, we believe Italy has attractive investment opportunities.