The EU should brace itself for the worst-case scenario. Those are the (rather disconcerting) words of European Commission president Jean-Claude Juncker last week in reference to Italy’s upcoming elections.
His fear is that Italy could end up without an operational government if the leading parties struggle to form a coalition, which could in turn prompt financial markets to stagger – although, unsurprisingly, his comments triggered a market wobble of their own as Italian 10-year bond yields increased.
While a hung parliament looks to be on the cards, a strong result from either anti-establishment party also threatens to shake up government policy, particularly if it forces another major economy to jump on the protectionist bandwagon.
There’s no question that the outcome of Italy’s upcoming election could be a key juncture in the future of the EU.
But should investors be worried?
For markets, there are two main risks that could emerge from the election.
First, is the rise of the controversial far right Northern League, or the populist Five Star Movement (M5S). Some pundits reckon that if either of these two parties come into power, they have the potential to hit confidence in the euro, potentially yanking it below $1.20 in the short-term.
Northern League’s controversial rise to power would be a wildcard for the economy. But James de Bunsen from asset management giant Janus Henderson says: “Despite some increased electioneering in the south of the country, the Northern League’s voting base is fairly localised, and we feel that they would only have limited influence in any right-leaning coalition.”
The second big risk echoes Juncker’s concerns that there could be no viable government following an inconclusive vote. It almost seems inevitable that the country will struggle to form a government, which means we could see the market slump in the short term.
Jordan Hiscott, chief trader at Ayondo Markets, says a hung parliament is arguably the worst case scenario for financial markets. “Italian equities are likely to feel the pressure with a change from centre-left government, and a potential hung result,” he says, adding: “my advice would be caveat emptor”.
With three different prime ministers in five years, Italy has become accustomed to political turmoil. It’s also worth bearing in mind that other European countries – such as Germany, Belgium, and the Netherlands – have functioned without governments for extended periods of time.
De Bunsen warns that the real danger goes beyond the immediate election. “As far as we are concerned, the real risk centres on Italy’s chronic debt-to-GDP ratio, its sluggish economy, and parlous banking sector. A lack of strong government policy deriving from an inconclusive election outcome makes it even less likely that these issues will be firmly addressed.”
Just last week, Italian 10-year bond yields climbed around 0.8 per cent, widening the gap between the benchmark German 10-year bond.
“Given the uncertainty around the polling data, and the fact that small margins could make a big difference, we are worried that the spread between Italian and German government bonds is still too narrow,” says Nicholas Wall from OMGI.
The bond investor points out that a swing to Italy’s far-right Northern League could see it become the largest party in a centre-right coalition. Alternatively, a flood of silent voters towards the M5S could oblige President Sergio Mattarella to give this party the first chance to form a government. “Neither scenario is our base case, but both would see the spread widen on the uncertainty,” says Wall, adding that the market seems to be underpricing the risk.
While it seems inevitable that the aftermath of the election will create volatility in Italian government bonds, it’s also expected to present some attractive buying opportunities.
But does this election have the potential to fracture the entire EU?
The prospect of an anti-euro party gaining traction and playing a key role in Italian government policy would certainly reignite questions about the viability of the single currency.
However, the main populist party, the M5S, recently softened its stance on the Eurozone, as party leader Luigi Di Maio announced that he no longer believes it’s the right time to leave the euro.
This has of course diluted some of the market risk.
While M5S goes against the grain, Rob Burnett, head of European equities at Neptune Investment Management, says it would not be a disaster if the party were to succeed in being part of the government. He points out, for example, that while the party pledges to restructure Italian government debt, it’s expected to tackle this issue in a constructive manner.
Despite concerns that anti-establishment parties are crawling out of the woodwork, there’s a prevailing sense of confidence that this looming election will have a limited impact on the Eurozone. Even Northern League – which is the party that is most critical of the EU – is only expected to get between 12 to 14 per cent of the vote.
While a populist victory wouldn’t necessarily end up throwing Italy into chaos, it would no doubt be unsettling for supporters of European unity.
Miles Eakers, chief market analyst at Centtrip, says: “It is with a sense of great irony that Europe’s leaders may wish for a Berlusconi victory. Similar to the German and French elections, any victory for the populist parties will also weaken the euro and have a negative impact on European stocks.”
While many expected the UK’s populist shift to resonate on other European nations, recent elections have seen centre or centre-left governments prevail. But the EU may not emerge unscathed this time around.