Italy's election result could be seen as bad news for the Eurozone. Anti-establishment M5S and hardline center-right coalition Lega are polling, cumulatively, close to 50%. With no obvious victor, prolonged uncertainty seems unavoidable as the parties seek to form a viable coalition. What's more, Italy needs to maintain its fiscal discipline and reform agenda given its high public debt-to-GDP ratio.
But we believe that Italy's political woes are unlikely to contaminate the Eurozone economy or markets.
- Both M5S and Lega have toned down their opposition to the euro. In any case, withdrawal would require constitutional change, in turn requiring a strong parliamentary majority. So pressure for Italy to withdraw remains marginal.
- Greater instability in Italy is being balanced by the end to Germany's long-running coalition talks. The SPD's vote to join Chancellor Angela Merkel's party in a fresh coalition will ensure a strong voice for further integration within the German government.
- Markets have reacted calmly. The spread between the Italian and German 10-year bond yields, which acts partly as a gauge of political risk, widened by just six basis points, and remains 20bps lower than at the end of last year. Other peripheral spreads continued tightening.
Political risk globally has not gone away, and the key focus for markets is the rising trade tensions sparked by President Donald Trump's decision to impose tariffs on steel and aluminum. But the political events in Europe this weekend have not so far added to market fears. We maintain a broad risk-on stance: we are overweight global equities, and prefer Eurozone equities to UK stocks within Europe.