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Italy’s election: should bond investors beware?

Italy’s election: should bond investors beware?

On March 4, Italy will go to the polls to elect a new government. As well as having implications for an Italian economy that is still structurally challenged, the election is also the first significant test of anti-European Union (EU) sentiment in 2018.

Recent trends in polling imply that the Five Star Movement is best placed to emerge from the election as the largest single party in the parliament. However, under Italy’s new electoral system, its current support levels are too low for it to form a government in its own right, and nor does it does have alliances with other parties that would allow it to lead a coalition government.

As a result, the most probable outcomes are a grand coalition, led by either Silvio Berlusconi’s center-right Forza Italia party or Matteo Renzi’s center-left Democratic Party, or a center-right coalition led by Forza Italia.

If a stable coalition cannot be formed, a minority government or fresh elections are the alternatives.

The election result matters because Italy is still grappling with a number of structural headwinds to growth, despite the economy’s cyclical improvement over the past couple of years. An effective government is needed to push forward with much-needed structural reforms that will help lift growth and put the banking system and public finances on a more sustainable footing.

The absence of a strong government would leave most of these problems unaddressed. This could leave Italy as an economic underperformer over the longer term, keeping political risks persistently elevated.

Nevertheless, despite the challenging outlook, we think the near-term risks of Italy leaving the euro are slim. Neither of the parties likely to emerge at the head of a new government favour leaving the Eurozone. And even if a Euroskeptic government were elected, the constitutional barriers to a referendum on Eurozone and EU membership are high.

Moreover, the near-term economic and financial costs would dwarf those experienced during the financial crisis. “Italexit” risks are higher over the long term, especially if the country cannot break out of its low-growth and high-unemployment trap.

The Italian election has the potential to spark greater volatility in the BTP (Italian sovereign bond) market, which performed well during 2017. That said, it is a well-signposted risk, and a Euroskeptic government is unlikely. The BTP market should also receive further support from a European Central Bank (ECB).

Although the ECB is scaling back its program of asset purchases, a backdrop of weak underlying inflation means that it is likely to continue buying BTPs for some time. Furthermore, Italy is now running a current-account surplus and, therefore, exporting capital to the rest of the world.

As a result, the prices of BTPs are likely to remain supported in the near term, and we retain an overweight position versus German bunds. However, we continue to monitor political, economic and policy indicators very carefully, especially the potential for a faster tightening of ECB policy, a politically driven relaxation of fiscal policy or an unwinding of earlier structural reforms after the election.

Against the backdrop of Italy’s still-significant long-term challenges, we would be looking to reduce risk if BTPs continue to perform better than German bunds in the run-up to the election.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

ID: US-210218-58028-1

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