Italy: the political risks pile up

While global markets have focused on the longevity of the so-called Trump trade, there have been developments in the other key risk for 2017. The likelihood of a populist, anti-immigration, anti-establishment, anti-euro party coming into power in Italy just increased.

Last week, the Italian Constitutional Court delivered a long-awaited ruling on whether aspects of the Italy’s electoral law (“Italicum”) are unconstitutional. For markets, there were a couple key features of Italicum:

  • In a general election, there would be two rounds of voting, with the second round being a run-off between the two leading parties from the first ballot.
  • The winner of the run-off would get a supermajority of 340 seats, or roughly 55%, in the lower chamber of parliament. The remaining seats would be awarded on a proportional basis among the losers of the election.

Together, these features meant that a single party could have a significant concentration in power – a dangerous feature given the rise of populist party, Five Star Movement (5SM). The Constitutional Court’s decision was that the law partly violated the constitution. The second round run-off element was found to be illegal because it meant a party with relatively little support in the first round could end up with a large majority of seats. This element has now been eliminated. But other key aspects of the law were preserved, namely, if a party wins more than 40% of the vote, it will be awarded the “supermajority” of 340 seats.

The previous electoral law also meant that there were two different electoral systems in the two (equal law-making) houses of parliament, making legislative gridlock likely.  Now both houses will essentially have proportional representation and so their make-up will be more consistent. With the ruling being immediately applicable, the prospects of an early election have increased substantially.

So what?

Leader of the Democratic Party (PD), former Prime Minister Renzi, has signalled strong support for early elections, since he believes his party has a good chance of reaching 40% (and thereby being awarded the supermajority). Worryingly though, 5SM has also been quite vocal about calling early elections, suggesting that it too believes it can reach 40%. That means Renzi’s call for early elections would be a risky move.

In fact, current polls suggest that both PD and 5SM poll around 30%, while centre-right parties, including the populist Northern League and Berlusconi’s Forza Italia, are divided and far behind. Both PD and 5SM would need a big rise in support to approach the 40% threshold. This implies that a coalition government will probably be required to reach the majority premium.

What form would such a coalition government take? In this new proportional system, the leader of the most-voted-for party would be the front-runner to head coalition talks for the formation of a new government. If the PD party wins the most votes, we could see a post-election centrist “grand coalition” between PD and Berlusconi’s Forza Italia (plus the support of additional small centrist parties). Even in this more market-friendly outcome, the new coalition government would likely be weak, unstable, and ineffectual, with negative implications for the aggressive reforms that Italy desperately needs.

It could be worse

Unfortunately, it’s far from assured that a coalition between PD and Forza Italia would even be able to reach a majority of seats given that the joint support in the polls for the anti-establishment parties remains itself not far below 50%.

Indeed, in the past few weeks, there have been reports that 5SM has been discussing a possible post-election coalition with the anti-immigrant Northern League party and populist Brothers of Italy party. Together, it’s feasible that they could secure a majority and form a government. Unsurprisingly, although a coalition between the three parties may be their only route into the government, these reports have since been denied by all three. After all, apparently each party could potentially lose support if voters believed that an alliance with the other two was likely, so any perceived political proximity between the three parties would need to be concealed before the elections.

Such an alliance would be the most bearish scenario – not just for Italy, but Europe as a whole. It would rule with a very solid anti-immigrant, anti-establishment, and anti-euro stance. In addition, not only would such a coalition put additional pressure on the viability of the European Union and single currency, but as long-term supporters of Russia, it would also be a gift for Russia’s Vladimir Putin.

Overall, where do things stand?

The main conclusions from the recent political developments are that: elections are likely in 2017 (the first half given other political considerations in the second half of the year); a coalition government is expected, suggesting further delays to banking and labour market reforms; and, while the most likely coalition is one between PD and Forza Italia, the prospects of an anti-establishment coalition cannot be ignored.

Markets have already taken the political uncertainty as a negative. Italian 10-year government bond yields have risen some 30 basis points since the Constitutional Court ruling, and spreads between Italy and Spain are their widest since Berlusconi’s fall from grace five years ago. Has this move gone far enough? My own opinion is that the market is only pricing in the risks that a coalition government represents for Italy’s structural and economic reforms. I believe the risks of an anti-establishment coalition are still under-appreciated. It may be the case that, for Italian yields, the only way is up.

 

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