February 26, 2018 – Ever since the surprise Brexit referendum in June 2016, global investors have been closely watching European elections for signs that political instability might impact regional economic progress or equity markets. On March 4, it is Italy’s turn for general elections. Italian voters go to the polls to elect a new Chamber of Deputies (lower house of parliament) and Senate (upper house). We believe it is unlikely that these elections will produce an effective multi-party governing coalition for the following reasons:
- Under a new voting system, a party or coalition of parties would need to win 40% of votes in order to form a government.
- The latest available polls suggest that no single party would win the required 40%.
- The current center-left governing coalition, led by Matteo Renzi’s Democratic Party, seems unlikely to win more than 23%. This coalition has been successful in implementing a variety of structural economic reforms which have boosted Italian productivity. This coalition has also taken steps to recapitalize weaker Italian banks.
- A shaky right-wing combination of Silvio Berlusconi’s Force Italy and the anti-immigrant, anti-EU Northern League seems likely to win about 36%.
- Silvio Berlusconi is a former media mogul who had risen to become a populist prime minister. During his tenure, 2008–2011, he was accused of soft authoritarianism. A tax fraud conviction has disqualified him from running from office, but he continues to lead Force Italy.
- Even if a combination of Force Italy and the Northern League were to reach 40%, there is a possibility that the two parties will have a falling out over EU policies or other issues while trying to form joint policy positions and staff a cabinet.
- The anti-establishment, anti-corruption, and Eurosceptic Five Star Movement may win about 28%. However, its anti-establishment stance has led it to reject joining a coalition with other parties.
- If the parties cannot agree to form a coalition government, then new elections will be called. In the meantime, it is probable that a senior figure respected by all parties would serve as temporary prime minister.
We believe that an inconclusive outcome would be inconsequential for European equities:
- An inconclusive outcome would not pose a threat to Italy’s participation in the EU.
- Only a government led by the Northern League with limited policy input from pro-EU Force Italy would pose such a threat.
- Major reversals in pro-growth economic policies enacted under the Democratic Party are unlikely unless Five Star Movement wins.
- For years, the thin capitalization of many Italian banks has been a concern for both the Italian government and EU. Fortunately, Italy has made progress in merging, restructuring, and recapitalizing several weaker banks.
- Moreover, an increase in intermediate euro sovereign yields is supporting a widening of Italian banks’ net interest margins, improving their profitability.
- The overall European economy, including the Italian economy, has been strengthening. (See Figure 1 for European aggregate and Italian PMI).
- We do not expect Italy to face political upheavals or economic setbacks. However, if these do occur, we are confident the European Central Bank will offer its support to calm markets, even if such support were to entail a more extended timeframe for scaling back its purchases of EU sovereign bonds.
- Most importantly, Italian equities form only 4% of European market cap. (See Figure 2 for comparative country market-cap weights in the IEV ETF).
Italian and Eurozone Composite PMIs have reached high levels
(50 = long-term trend growth)
Data as of January 31, 2018
Market Cap Weights within the MSCI Europe Index
Data as of February 20, 2018
Our expectation is for continued improvement in European corporate earnings and share prices. With the European economy improving, we expect earnings recovery to broaden from globally oriented multinationals to more locally focused companies such as banks. Consequently, we maintain an overweight to International Developed equities.
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