Hectic Weekend for the EU
This weekend might be the most important on Europe’s political calendar so far this year. On March 4, Italy goes to the polls, while Germany’s Social Democratic Party announces whether they will join a grand coalition with Chancellor Angela Merkel’s Christian Democratic Union.
Ahead of Super Sunday, speculative traders are reducing their euro exposure to its lowest level in 2018, according to the U.S. Commodity Futures Trading Commission.
Euro traders are turning wary of rising political risk. Should the outcome force new elections in either or both countries and extend the period of political uncertainty, the euro is in for a selloff. “The story for the euro this week is one of caution…We see politically-induced downside risks for EUR/USD this week towards 1.2100/30” said Viraj Patel, FX and Macro strategist at the ING Group.
An Economy Plagued by Spare Capacity
In Italy, whoever becomes captain on March 4 will have their work cut out for them.
The eurozone’s third-largest economy has had a rougher ride back to recovery. The output gap is at -3.32%. For comparison, the eurozone average is -1% and Germany is running close to 0%, according to the latest Bloomberg intelligence. The economy has expanded for 14 straight quarters at a 0.5% rate but is still expected to remain under its pre-crisis level through 2022. The March 2015 Job Act, a labour law overhaul from the Democratic Party, has created almost 1m jobs but two-thirds of them are temporary. In the last decade, the number of Italians at risk of poverty rose by more than 3m to 18m. That’s 30% of the population. The housing market isn’t painting a better picture either, with the house nominal price index down 85% since 2010.
Likely Outcomes (or Lack Thereof)
A grand coalition led by the Democratic Party and Forza Italia would secure a market-friendly continuation of the political status-quo. But unenthused Italians feel bleak about the tepid recovery toward lasting prosperity and question the governing Democratic Party’s ability to accelerate reform. The polls are torn three ways: the ruling party together with a loose grouping of center-leftists have 28% of votes according to latest polls, giving rise to the anti-establishment, eurosceptic, technology utopian, 5 Star Movement with about 27%; and a centre-right coalition led by former prime minister Silvio Berlusconi at 35%.
The rosatellum, the new Italian parallel voting system, is likely to exacerbate uncertainty. Part first-past-the-post and part proportional, it makes it harder for parties to reach the 40% threshold of the vote necessary to secure a parliamentary majority. Not surprisingly, this system, brought by Renzi and Berlusconi, is not in favour of groups with no natural coalition allies like M5S.
The good news is, since no party is expected to win an outright majority, entrenched interests, like leaving the EU, would hardly materialise. At this point, a hung parliament or even a re-election are still on the table.
Italian Equities: Election Isn’t Armageddon
Amidst all the uncertainty, the Italian benchmark FTSE MIB Index still closely tracks the Euro STOXX 50, illustrating a market view that the election is more of a domestic issue than an event with larger systemic implications.
Although consensus lies with mild equity market impact, tail risk should not be ignored, according to UBS. Specifically, companies with significant domestic sales and operations and higher debt burdens are the most vulnerable to a price drift, while Italian large caps with international top lines and strong balance sheets shouldn’t feel as big of a subsequent market shock after the polls close.
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