Italian elections are often dismissed as an opera buffa, and this Sunday’s vote is no different. A new electorate system, the political comeback of Silvio Berlusconi and the insurgent Five Star Movement have dominated news flow. But as the eurozone’s third-largest economy prepares to go to the polls, we assess the investment landscape in Italy.
Italy is no stranger to political instability. The country’s political history has been defined by short-lived governments, with 65 administrations taking the helm since World War II, each one lasting for a little more than a year on average.
Elections are frequent and post-electoral horse-trading between political parties is common. Between 1945 and 1994, the Christian Democrats took a leading role on the political stage. Thereafter, power swung between the centre-right and centre-left parties. Since December 2016, Italy has been under the caretaker leadership of Paolo Gentiloni, following Matteo Renzi’s resignation as prime minister after his referendum to reform the Senate failed to secure the nation’s approval.
On 4 March, Italian politics will be thrust back into the spotlight when the country heads to the polls for a general election.
The economy has enjoyed an impressive return to growth since the 2013 general election, but it is still lagging behind its European peers. Moreover, public debt levels remain high at €2.3tn, and there has been little discussion about the country’s long-simmering banking crisis. Nevertheless, markets are dismissing an election shock. But this complacency may not last.
The election conundrum: gridlock or grand coalition?
The final opinion polls released ahead of the parliamentary election showed Silvio Berlusconi’s centre-right alliance has a clear lead but not enough to win an overall working majority, thereby pointing to political gridlock1.
Under Italian election rules, polls cannot be published in the final two weeks of campaigning, making it difficult to predict the election outcome.
Adding to uncertainties is the country’s new and complex mixed-member electoral system, dubbed the Rosatellum, which will be used for the first time on Sunday. Unlike the previous system, it does not give an automatic majority to any party that wins more than 40% of the vote. Instead, some 36% of parliamentary seats (in the lower and upper houses) will be awarded on a first-past-the-post basis, while the remainder will be chosen by national proportional representation.
There are five possible election outcomes:
No major economic risk in the near-term
Political parties have shifted their focus to the economy in the final weeks of campaigning, after the final polls showed no overall winner. Forza Italia is pitching tax cuts to drive faster growth, while the Five Star Movement is proposing a work-for-benefits scheme called “citizen’s income”, and the PD intends to introduce a minimum wage. The political parties have also committed to tackle the country’s mammoth debt pile: Forza Italia is pledging a 30% debt reduction in five years, the PD promises the same reduction in 10 years and the Five Star Movement vows to achieve a 40% cut the next decade.
Silvia Dall’Angelo, Senior Economist
In the last year, Italy’s economic recovery has gathered pace, reflecting the recent synchronised upturn in global demand. The country recorded annual GDP growth of 1.6% in 2017 – its fastest pace of growth since 2010. Although business investment and exports accelerated on the back of external demand, consumption growth has stalled, reflecting lingering concerns and a slowly healing labour market.
For the Italian economy, the short-term outlook is constructive due to its high sensitivity to external demand. This in turn makes it well positioned to reap the benefits from the ongoing up-turn in the global economy.
Although near-term risks look contained, in the medium-term, challenges remain. The country needs structural reforms to regain competitiveness. This hinges on the election outcome and the new government’s ability to deliver much-needed economic and structural reforms. A couple of observations stand out:
This suggests that the election will probably lead to some sort of coalition government with a weak mandate. On a positive note, a coalition government would imply substantial policy continuity. This means it is likely that fiscal discipline would continue, allowing for a gradual reduction of the debt/GDP ratio, which at 132% is one of the largest in the developed world. In addition, the pursuit of controversial policies, such as leaving the euro, would be extremely unlikely. However, a coalition government probably would not have the political capital to put forward the necessary structural reforms. Although the government has attempted to address some structural issues in recent years, weaknesses continue to weigh on the country’s growth potential, as evidenced from its sluggish labour productivity growth.
Bonds and banks: a tension-free election build-up
The weakness of the country’s banking sector and its mammoth debt pile have also been a drag on economic growth for the past decade.
Filippo Alloatti, Senior Credit Analyst
Bond markets are usually sensitive to political risk. But at present, they look unperturbed by the looming election. That will change in the immediate aftermath of the election result, as investors watch Italian banks’ credit spreads and Italian government bonds (BTPs) very closely. Italian banks’ credit spreads and BTPs are interrelated as BTPs and supranational agencies account for 18% of banks’ total assets, compared to the EU average of about 10%.
Italian bond markets have proved resilient in the build-up to the election, buoyed by a robust EU economy and the downplaying of anti-euro messaging by some political quarters. Since the start of the year, Italy’s 10-year bond yield spread has been tightening, suggesting investors are unruffled by the election. Last week, some unease crept into the market, pushing Italy’s 10-year bond yield spread over Germany to its widest since January. However, the yield spread is still close to where it was in early February, which was its tightest spread in over a year.
Some pre-election volatility could be seen as an opportunity to snap up Italian debt. However, it is important to look towards the election outcome, which is expected to produce political deadlock. In the event of a hung parliament, spreads could widen as it would take time for parties to form a coalition. Eventually a government will be formed and we don’t think new elections are on the cards.
Moreover, the election occurs just three months after the European Central Bank began tapering its bond-buying programme from €60bn to €30bn a month. Italian bonds have been one of the biggest beneficiaries of quantitative easing (QE). And while there is sufficient demand from other investors for BTPs, a surprise election outcome could prompt the ECB to extend QE beyond its September end-date.
Meanwhile, the banking sector has made progress in dealing with the mountain of non-performing loans (NPLs) and raising capital to strengthen balance sheets. But the sector is still recovering. While private and public capital has resulted in a reduction in NPLs, the job is not finished yet. Italian banks still account for around a quarter of the eurozone’s NPLs – the largest in the EU. However, the latest data from the Bank of Italy showed that the stock of NPLs fell 5.5% in November to €173bn, compared to the previous month. Although NPLs have weighed on banks’ P&L through increasing loan loss provisions, negative rates (i.e. Euribor) have proved more painful to banks’ profitability. Nevertheless, the new government must continue to address the problem of NPLs and reinforce the system’s capitalisation.
Italian equities: a buying opportunity?
Equity markets have been similarly unshaken by the impending election. In January, Italy was the best-performing stock market in Europe, and it has continued to gain momentum despite the return of volatility last month.
Lewis Grant, Senior Portfolio Manager, Global Equities
Italy’s benchmark FTSE MIB index has gained about 4% since the start of the year, compared to the pan-European Euro Stoxx 600 which has lost more than 2%2.
This robust performance highlights its resilience to political uncertainty in the face of a seemingly negative outlook. The possible outcomes of political deadlock, fresh elections or a grand coalition all suggest little hope for meaningful reform or productivity gains. Moreover, although eurozone data points to robust and sustainable growth, Italy has been a laggard, and there is little to suggest that these elections will improve matters.
The strong performance of Italian equities has been led by bargain hunters. At present, Italian equities continue to look relatively cheap, and have therefore attracted investors buying up heavily discounted stocks, particularly in the banking sector. Bank stocks have been the big winners in 2018, as progress in stabilising the banking sector and positive economic data has restored investors’ appetite for Italian assets. Last year, the Italian government committed €17bn to wind down two Veneto-region lenders and nationalised Banca Monte dei Paschi di Siena, which were considered by many as the biggest sources of systemic risk facing the industry. But more steps need to be taken by the new government to ensure the banking sector’s recovery continues.
We have exposure to Italian bank UniCredit, whose geographically diversified revenue stream allows the bank to generate growth in other markets. As such, the company is less sensitive to Italian politics and a potential slowdown in the nation’s economy following the election. In the event of any short-term, sentiment-led market volatility, we may see further buying opportunities in such names.
For now, calm prevails
The uncertainty of any major general election is always likely to pose some risk. However, despite a fragmented political landscape and a new untested electoral voting system, markets remain calm, for now. This might change in the immediate aftermath of the election as investors digest the outcome. Investors must therefore pay attention to the investment opportunities – and obstacles – that emerge from one of the most uncertain political contests in Italy’s history.
1 “Uncertainty reigns in final polls ahead of Italy election,” published by Reuters as at February 2018
2 “Italian stock market outruns European peers,” published by the Financial Times in February 2018