An old Tuscan proverb claims that “after the game, the king and the pawn go into the same box”.
Would the upcoming elections in Italy turn out to be as what the proverb claims?
Political uncertainties have gripped Europe since the fated Brexit vote, and Italy is widely seen to be a poster child of the rise of populism in the West. In fact, according to a paper by Bridgewater Associates, populism is at the highest level since the 1930s:
Concerns surrounding unemployment and immigration, and frustration against incumbent politicians have led to a rise of populist factions (both left and right) in Italy. The situation is compounded by relatively high debt levels in Italy, which limits the scope for fiscal stimulus measures such as lowering of taxes or government spending. Polls conducted by Instituto Ixè are as follows:
The leading parties are the anti-establishment Five Star Movement (M5S), the incumbent Democratic Party (DP), and the centre-right party Forza Italia. On their own, they cannot form a majority, which leads everyone to conclude that a coalition government is inevitable.
While they have toned down their anti-establishment rhetoric, M5S’s popularity is a concern among other European politicians and global businessmen. They have also previously claimed that they will not work with another party, and other parties have also expressed that they will not cooperate with M5S. This leaves the Five Star party a lame duck even if they get most of the votes (a comforting thought for investors).
Additionally, the new Rosatellum law which came into effect late last year meant that parties with similar ideologies can establish a coalition. This means that a centre-right or centre-left coalition can form a government (refer to the table above), which also suggests that the centre-right coalition of Forza Italia and Northern League has a high chance.
The possibility of an Italxit, while clearly possible, is low at this point. This is because the current constitution does not allow referendums for international treaties and agreements, and membership in the EU is considered to fall under this category. If the new government wants to hold a referendum on EU membership, the constitution has to first be amended.
The next few charts show that market participants are not particularly troubled by this high key political event yet:
Credit default swap spreads are way off from the highs seen since the days of the sovereign debt crisis.
The spread between the Italian 10-year government bond against the German 10-year bund also indicates that market participants are not exactly pricing in a political risk premium into Italy’s sovereign debt yet.
As of end-January 2018, Baker, Blooms & Davis’s proprietary economic policy uncertainty index also suggests that levels of uncertainty in the media are still far off the levels seen during the sovereign debt crisis.
The FTSEMIB options market tells us that implied volatility on options 12-months and shorter to expiry has risen over the past few weeks, but it could be because of the recent sell-off in global equity markets at the end of January. I expect IV levels to actually be higher going into the event as political uncertainty creeps back into the scene.
Which leads to my base case, which is that either the centre-right coalition would take power or the centre-left prevail. While the incumbent DP has seen a dip in popularity, voters may also feel that they do not want to rock the status quo. There is also a possibility that the centre-left will compromise for a wider coalition. As for the centre-right, time would be needed to find out what kid of policies the centre-right coalition would implement should they form the majority.
Should the outcome turn out as such, the market narrative would turn back to the European cyclical recovery story that everyone has been focused on since early 2017. In fact, despite the pessimism, data in the periphery has been improving. This was evident with the positive reassessment of credit ratings in Spain and Portugal last year.
Business confidence (as gauged by Markit’s PMIs) in Italy remains strong, which probably suggests that Italian corporations are not very concerned with the upcoming elections at this juncture. Capex and employment is expected to remain supported with such improving sentiment.
Capacity utilisation in Italy has also been trending upwards, confirming a cyclical recovery:
The other highly probable scenario is a situation whereby no one faction fall short of the threshold needed, which could lead to a stalemate (again), a trend not uncommon in Italy’s political history. That would lead to more noise ahead as the factions negotiate with one another, and market participants may just take everything in their stride once again.
The third probable scenario is M5S winning an outright majority.
If these two above scenarios materialise, the course of action will be to wait and monitor developments. There are times when doing nothing and watching for cues is the prudent thing to do.
So at this moment, the risks are (hopefully) grey swan in nature, and probably still within control.
Higher volatility could be expected as the days near to the election, and if my base scenario happens, there could be selective opportunities to fade the markets and scoop up exposure in attractive areas and segments.
I would avoid sovereign debt and credit exposure, but certain Italian companies that derive a majority of their revenue in faster growing economies will be interesting opportunities should their share prices be caught up in any knee-jerk reactions. Companies such as Ferrari (RACE), Luxottica (LUX), FIAT (FCAU) and Davide Campari Milano (CPR) fit the bill.
However, during the next downturn in the business cycle in Europe, especially when the credit cycle turns, things could be drastically different…