Italian Elections Tipped to Put Euro Under Pressure vs Pound Sterling and Dollar

Political risk is back on the agenda for the Euro exchange rate complex with the outcome of the German election reminding investors that the Italian election has the ability to destabilise the Eurozone

After a quiet summer, the prospect of disruptive politics is once again playing its hand in the Euro’s direction.

The unexpected outcome in the German election has reminded markets that discontent amongst voters is not to be ignored and minds have already turned to Spain’s Catalonia where secessionists are advocating for a vote on independence,

The outcome has seen the Euro retreat below 1.18 against an increasingly confident US Dollar and going below 0.88 against the British Pound.

With politics back on the agenda, we have noted the Catalan issue has the potential to push the Euro 5% lower here.

Arguably even more significant to the Euro is Italy where campaigning for an early-2018 election is due to get underway imminently.  

Insurgent anti-Euro forces in Italy, combined with the country's fragile economy and weak banking sector, mean these elections present a far greater threat to the post-crisis calm in Eurozone financial markets than Sunday’s German election.

“The return of the ‘populist voter’ in a European election is a reminder that political risks haven't completely abated for the Euro – especially with the spectre of the possibly more contentious Italian elections looming in early 2018,” says Lee Hardman, an analyst at MUFG.

Manuel Oliveri, a strategist at Credit Agricole CIB, agrees:

“We believe this weekend’s outcome is unlikely to trigger downside risks for the EUR. In terms of political event risk, next year’s Italian election should warrant greater attention.”

Going by current opinion polls, the fragmented landscape of Italian politics is unlikely to yield a commanding majority for any one party at the May 2018 vote, which means a hung parliament or a coalition government is likely.

"Opinion polls continue to suggest that the most probable election outcome will be a hung parliament and stalemate," says Dr Loredana Federico, chief Italian economists at Italy’s largest bank, UniCredit.

There is the prospect that sentiment towards the Euro fades in such an environment, opening the door for Pound Sterling to rally higher, particularly if decent progress is seen being made in Brexit negotiations in early 2018.

Italy is Not Greece, Spain, the Netherlands or Germany

The rise of anti-establishment parties has threatened to upend the established order and has seen elections in Europe take centre stage for investors in 2017.

The prospect of an anti-market outcome has kept the Euro suppressed but the status quo succeeding in the Netherlands and France prompted markets to believe the threat of surprise had been overcome and European voters will behave and vote in traditional patterns.

“Unlike the Dutch, French and German elections where alternative parties were never in realistic contention to form a government, an alternative, anti-euro party, the Five Star Movement (M5S), is at rough parity in the polls with both the centre-left and the centre-right blocks,” says Tomasz Wieladek, an economist at Barclays.

Insurgencies in the Dutch, French and German elections were also largely confined to a face-off between single-issue protest parties and incumbent establishment forces.

But Italy’s election will pit the 5 Star Movement, a protest party that has much broader appeal than those in other European elections and a full policy agenda to boot, against a set of damaged incumbents and weaker challengers.

“This could well be a concern for medium-term real money investors (eg, reserve managers), while any waning EZ recovery sentiment could see a pause in the cyclical EUR upswing,” says MUFG’s Hardman.

The stakes on the table could not be greater. With implications for the Eurozone aside, the Italian economy is among the world’s ten largest and is one of Europe’s most fragile after having only recently, in 2016, emerged from the depths of a post-crisis depression.

In addition, Italy has a banking sector that is weak and wobbly enough for it to have been a persistent concern to investors and policymakers, and large enough for it to threaten global fallout if something serious goes wrong.

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5 Star Vying With Democrats Over 1st Place In The Polls

The insurgent 5 Star transcends traditional political lines of right and left, relying on a direct democracy approach to governing and using online polling of its members to determine the party’s position on all issues.

The freedom from labels such as right and left has a place in European politics, as shown by the success of Emmanuel Macron's En Marche.

The concern for markets is M5S’s pledge to renegotiate the European treaties on fiscal responsibility and the Euro, with a view to securing more leeway on European rules around subjects including budget deficits and austerity.

Contrary to popular belief, the party supports Italy’s membership of the European Union, although it has pledged a nationwide referendum on the Euro if it is unsuccessful in securing a renegotiation of the treaties.

The party elected a new leader, 31 year old former waiter Luigi Di Maio, at the weekend which saw the victor take 30,000 votes out of the total 37,000 ballots cast.

For now analysts do not expect the party to lead.

“The M5S (Five Star) is unlikely to reach the 40% threshold needed to gain a majority premium in the lower house, which would allow it to govern without alliance,” Federico says.

Renzi's Party Struggles

On the opposing side of the field, former Prime Minister Matteo Renzi’s democrats, who head the current government under Prime Minister Paolo Gentiloni, are vocal supporters of the EU and Euro.

“The PD continues to struggle to visibly increase its share in the polls: the vote share is currently at about 27%, on average, slightly up from the low of 26% seen in February, after the party’s split,” says Federico.

Renzi’s Democrats have been hindered by the legacy left behind by years of austerity measures, a failed referendum on constitutional reform in December 2016 and last year’s bank bailouts that saw the government propping up a series of failed lenders with more than €17 billion of new cash and debt guarantees.

“We acknowledge the risk that, when the election date arrives, many undecided voters might opt to support the M5S with their main aim being to foster change among the political actors and vote against mainstream parties,” says UniCredit’s Federico.

Berlusconi Returns But Will A Centre Right Coalition Prevail?

Former Prime Minister Silvio Berlusconi, the billionaire magnate renowned for sex scandals and a 2013 conviction for tax fraud, is polling on around 13% support with his Forza Italia party.

A possible centre-right coalition between Forza Italia, the anti-immigrant Northern League and the Brothers of Italy party is seen as being a possible outcome in the election for ideological reasons although their collective poll numbers are inadequate at present.

“This party’s [Northern League] vote share has been on the rise recently and is now only slightly below 15%, on average... concerns of the Italians about immigration and the promise of fierce opposition to fiscal austerity and the announcement of a move towards a flat tax (while, at the same time, softening its Italexit stance) continue to boost electorate support,” says Federico.

Berlusconi, whose ability to stand for office will depend on the outcome of a November European Court of Human Rights appeal, has caused controversy in the past by putting forward the idea of introducing a parallel currency for domestic use in Italy.

However, as the campaign season has drawn closer, Berlusconi’s more recent proposals have advocated continued membership of the Euro and deeper integration within the European Union.

“While it is clear that Forza Italia will move towards some of the populist positions of the Northern League (e.g. in terms of immigration), we also highlight that Mr. Berlusconi is aware that Forza Italia’s potential electorate is moderate and pro-European and hence his party has to seek a center-right alliance that maintains moderate positions, for example on EU issues,” Federico adds.

A 2013 conviction for tax fraud led to Berlusconi being banned from holding public office again before 2019, although his appeal to the European court suggests the ban is not set in stone.

Collectively, the three parties have around 33% in the opinion polls which makes them a contender for the largest grouping of challengers, but is still short of the 40% needed to gain a majority in the lower house of Italy’s parliament.

November’s Local Election In Sicily An Important Test  

Italians will vote in a key regional election in Sicily on Sunday 05 November, which is widely seen as an important test of campaign strategies and alliances ahead of May’s national election. The prize for winning is an influential and coveted Governor of the Region position.

“The M5S will run alone and seek confirmation of the high level of support it has always benefited from on the island, mainly as the gap in the economic performance vis-à-vis the rest of the country may fuel high discontent towards traditional parties,” says Federico.

Berlusconi’s Forza, the Northern League and Brothers of Italy have put forward a single candidate under a united banner. This combination worked well for the trio at earlier regional elections, back in June. Renzi’s Democrats and a series of smaller centre-left partners are running their own candidates.

“Another success in the region, after the good results achieved by the center-right coalition in the municipal election in June, would give the coalition further momentum,” says Federico.

While September marks a beginning of the long march toward next year’s election, the November 05 vote in Sicily will be the first major battle of the campaign.  

Watch The Banks!

There is the possibility that the Pound-to-Euro exchange rate could move in response to moves in the share prices of Italian banks over the coming months for indications of market expectations around the Italian election.

Should 5 Star gain momentum, or investors’ nerves falter on the ground, Italian bank stocks will fall before upset or uncertainty sideswipes the Euro. Initially, price movements will be wider and more readily singled out than they could be in bond markets.

This is because Italian bank bailouts still remain an agenda item to this day, nearly ten years on from the financial crisis, as weak capital buffers and elevated levels of sour debt have proven insurmountable for many lenders.  

Fact: The total value of defaulted loans across the sector as a whole is equal to nearly 20% of all loans in issue in Italy - something which has hampered previous efforts to strengthen the sector’s collective balance sheet.

Italy’s three largest banks by assets are UniCredit, Intesa Sanpaolo and Monte dei Paschi.

Monte dei Paschi’s share price has done nothing in 2017 because the bank was nationalised in a bailout back in December 2016.

UniCredit and Intesa have seen their share prices rise by 25% on average during the year to date and by around 8% each during the last three months, to trade at €17.45 and €2.96 respectively on Tuesday.

This strong positive performance will falter and reverse fast should Italian and international investors become more cautious of a possible election upset in the months ahead.