Italian Election--Two Months and Counting

Germany does not have a government, though the election was more than three months ago.  Spain, Portugal, and Ireland have minority governments.  Austria is the first government since the financial crisis to include the populist right.  The EU is trying to press the Visegrad group of central European countries to conform to the values of Western European members.  And yet it is Italian politics and the election on March 4 that are drawing attention.

Investors do not seem to care much about political developments provided they are local and do not pose systemic risk.  Italy may pose such risk, the argument goes because the largest parties want to ditch the euro.  Perhaps learning a lesson from Greece's experience, the Italian politicians are more circumspect. 

Still, the Five Star Movement, which is polling first in surveys, has pledged a referendum on the euro if Brussels does not change its fiscal rules.  There is little chance that the Stability and Growth Pact will be abandoned at the request of the second largest debtor in the bloc.  Moreover, as EU and ECB officials have pointed out, there is some fiscal flexibility built into the rules.

Berlusoni's Forza Italia and Salvini's Northern League are critical of the EU and EMU, but rather than jettison the euro, they talk about having a parallel currency.  Of course, investors have to take the rhetoric seriously, but that is what it is- posturing.  First, unlike Greece or the UK for that matter, Italy cannot have referendums on treaties.  Therefore, to hold a referendum on EU or EMU would require a change in the Italian constitution, which is designed to be difficult to do.

Second, as Draghi made clear at a recent press conference when asked about Estonia's desire to have a digital currency, there is only one legal currency in the EMU and that is the euro.  The introduction of a parallel currency in Italy is a non-starter, though that will not stop some politicians from talking about it. 

The most likely electoral outcome is that neither of the three main political groups (Five Star Movement, Forza Italia and the Northern League, and the PD) secures a majority.    A coalition remains the most likely scenario.  The Five Star Movement eschews coalitions and alliances.  This is one of the reasons that the party felt cheated by the new electoral law which is more like German rules rather than the Greek model that gives bonus seats to the victor to secure a parliamentary majority.

Investors, like other observers, have a difficult time classifying the Five Star Movement.  On some issues, it seems on the Left.  The five stars refer to the initial planks:  sustainable transportation, public water, environmental protection, anti-corruption, and right to internet access.  On other issues, like immigration (anti), foreign policy (pro-Russia) and EMU (critic), it has much in common with France's National Front.  

There also appears to be an authoritarian streak in the party, though part of it seems to be a response to the lack of party discipline in Italy. There has been a high number of MPs that switched parties.  In the last parliament that was elected in 2013, 345 members changed their party affiliation.  Some even switched more than once.  That translates to nearly a third of the Chamber of Deputies and more than 43% of the Senate.  Also, recall that when that parliament was elected, 15 parties were represented.  When parliament was dissolved at the end of last year, there were 23 parties, including a handful of one-member parties. 

However, the democratic centralism of the Five Star Movement may go too far for many.  Party members must sign pledges not to deviate from the party line set by the leaders or face expulsion. Recently the fine for being expelled from the party or leaving one's post doubled to 100k euros.  That said, there have been some recent signs of some relaxation of the iron-fist discipline on the margins. 

Until last year, the Five Star Movement had allied itself with UKIP in the European Parliament.  However, now it is part of the Alliance of Liberals and Democrats for Europe, which like the Free Democrat Party in Germany.  Many Americans may be confused by the European use of the word "liberal".  In the US, the term has come to be used by some politicians and observers as an epitaph for a mild form of social democracy.  In Europe, liberal remains more anchored by its roots--liberty.  In Europe, the liberals tend to be pro-business, and more so that the Five Star Movement seems. 

II. Initial Investment Implications

Italian assets have already begun underperforming and this should be expected to continue on a trend basis into the election.   The Italian premium over Germany on 10-year bonds bottomed last year as speculation of the election began in earnest.  It was near 135 bp.  Recall that the low in 2016 was just below 100 bp and the low from 2015 was near 90 bp, which was the lows since the European crisis erupted in 2010.  During the heart of the crisis, the Italian premium exploded to over 550 bp. 

The premium reached nearly 163 bp this week.  Even though the ECB is continuing to buy sovereign bonds and the modest deviations from the capital key appear to favor Italy, it would not be surprising to see the premium rise to 200 bp, which was seen in H1 17 and is the upper end of the range seen over the past four years.  

For some investors, Bunds and BTPs are not substitutes for each other, even though ostensibly they share currency risk, which is typically the key to total return.  Some investors may choose to shift from one part of the European periphery to another.   In this context, it means Spain or Portugal, which would help a portfolio maintain its yield.   The Italian premium over Spain has more than doubled to 48 bp in the past month.  The premium peaked in 2017 ats a little more than 75 bp, which was the most in five years.   If the new Catalan government will not repeat last year's secession attempt, the Italian premium can return to 75 bp if not beyond ahead of the Italian election.  

Positive developments in Portugal, leading to rating upgrades in the last few months of 2017.  Since the S&P upgrade in mid-September, the 10-year differential has moved from about 85 bp in Portugal's favor to 15 bp discount a few days before Christmas.   Portugal now trades at a 10 bp discount to Italy.  This is the first time since 2008-2009 that Italy offers a premium over Portugal.  

Moody's has a negative outlook for Italy's (Ba2) rating, and a positive outlook for Portugal (it did not upgrade the rating in 2017 when S&P and Moody's did).  S&P is to review Portugal again just after the Italian election.  Fitch reviews Italy' (BBB) rating in the middle of March and S&P will announce the results of its review (BBB) in April.  Both S&P and Fitch have positive outlooks for Spain (BBB+) but update their reviews in late March and July respectively.  

The Italian stock market has risen a little less than 1% of the past month.  Europe's Dow Jones Stoxx 600 has risen 1.75% at the same time.  That includes Italy's outperformance this week.  In the first three sessions, the FTSE Milan Index has risen 3.25%, easily the best performer of the major European bourses. 

If an increase in the risk premium for Italian bonds is among the clearest implications in the run-up to the Italian election, then what are the implications for Italian equities.  Conducting the correlation on the level of the Italian equity market and 10-year yield, over the past 100 days the correlation is -0.30.  The correlation on the basis of change or percentage change, the correlation is about -0.15. 

Drilling down, we looked at a few sectors.  Over the past 100 sessions, bank shares and bond yields turned (slightly) positively correlated (percentage change) for the first time since 2010.   The correlation between Italian insurers and the 10-year bond yield had turned positive in November and most of December, but has been weakening and is now slightly negative.  The correlation between Italy's real estate sector and bond yields is more stable than the other two sectors, and is around -0.20 over the past 100 days on a percentage change basis and -0.80 on the basis of levels.