Why markets may not mind about Merkel
On 4 March, the German SPD will announce its decision on whether to join a grand coalition government. The Italians will have a general election. Markets probably will not care too much.
The German decision will at least be a decision. There is unlikely to be a major change of policy direction, whatever the decision. A minority government or elections would raise uncertainty if the SPD say "no" to a coalition. Policy uncertainty would still be limited.
The Italian election result is unlikely to produce a quick decision. Our base case is a centrist grand coalition. This will take time to negotiate. A technocrat government or new elections will also take time. The immediate outcome is political uncertainty. Uncertainty is not exactly unusual in Italian politics. Investors are unlikely to be shocked.
Domestic investors react to political risk. Foreign investors overreact to political risk. The number of foreigners in financial markets drives how important political risk is for markets. European markets and the euro depend on domestic investors. They are unlikely to overreact to European political noise. US markets and the dollar are more dependent on international investors. The US midterm elections may be the greater political risk this year.