Blog Posts — February 26, 2018

High noon in Europe as key votes loom

by Christoph Schon, CFA, CIPM

Sunday, March 4, will be an “interesting” day for European politics, with two votes that could be crucial for the future of the European Union: the Italian parliamentary election and the decision of the German Social Democratic rank and file on the proposed coalition deal. Both have the potential for a negative surprise—as markets appear to be complacent about the results of either—which could ultimately be bad news for the euro.

The growing support for Eurosceptic, populist forces in European Union member states has been a major concern for investors ever since the shock outcome of the British EU referendum in June 2016. Stock, bond and currency markets reacted very sensitively to opinion polls in the run-up to the French election in the second quarter of last year. The euro dropped 1.3% against the USD and Bund yields fell by 6 basis points once it became clear that the strong entry of the far-right Alternative for Germany (AfD) into the German parliament would make it extremely difficult for the more moderate parties to form a stable government—confirmed by the fact that even 5 months after the vote, Europe’s most powerful economy is still without a new administration.

The latest opinion polls for the Italian election indicate the Eurosceptic Five Star Movement (M5S) as the frontrunner with 28% of votes. Combined with the 13.5% of the also anti-euro Lega and the close to 5% for the nationalist Fratelli d’Italia (FdI), this puts EU-critical support to nearly 50%. However, the FdI has already withdrawn a potential euro-referendum from its manifesto, while the M5S has also shifted its focus on the more pressing issues of fiscal deficit and unrestrained migration from North Africa. We therefore think that the risk of an “Italexit” is receding.

The bigger risk is, in our view, that the Five Star Movement—who have already claimed that they are not looking to form a coalition with anyone—will get so many votes that they disrupt the composition of the Italian parliament such that it will be impossible for either of the other parties to form a government, but still not enough to govern on its own. With 35% of the electorate stating that they are still undecided, this is a distinct possibility.

Granted, markets are fairly accustomed to political uncertainty and instability in Italy. But the fact that two of the biggest economies and net-payers into the EU budget might be without a functioning executive for an extended period could put a lot of pressure on the euro.

In Axioma’s recently released study, The German Coalition Quandary, we looked at the potential impact of a failed coalition deal and possible new elections in Germany on a euro-denominated multi-asset class portfolio. We found that a 15% depreciation of the euro against the USD could translate into equity market losses of between -3% for economically stronger countries, such as Switzerland and the Netherlands, and -10% for other nations, such as Italy and Spain, when using correlations and betas from the run-ups to the French and UK elections in Q2 2017. When calibrating the stress test during the more turbulent weeks around the Brexit referendum, the same losses extend to -17% to -30%, respectively.

Grazie mille to my colleagues Luciano Bianchi and Samuele Marello for their valuable insights into Italian politics.