Wishing Upon 5 Star

Ballots are still being counted in this weekend’s Italian election but the picture is becoming clear, with two parties emerging stronger from the ashes of a bitter electoral campaign: 5 Star have estimated to have polled 32% and the far right Lega (a.k.a. Northern League) have 18%, but no one coaltion can claim a victory.

The solution that was theorised in the days preceding the election –  a centre-left and centre-right coalition – is not viable anymore. The two personalities of the past few years, Renzi and Berlusconi, barely reached a third of the seats when combined so they will not be primary forces of the next executive. 5 Star, on the other hand, got the vote of 1 in every 3 citizens, dominating the southern regions almost completely. Such a result can’t be ignored by the president, whose duty it is to nominate the prime minister, when choosing the next government at the end of March. The anti-establishment party will have to be at the centre of any negotiation to form a majority.

The two most likely scenarios we can see are a coalition between 5 Star, the extreme left and Renzi’s party, or a protest-vote coalition of 5 Star with Lega. The second scenario is likely the more probable one given the left-leaning coalition would have to overcome a number of internal fights. A third scenario would see the left wing together with the centre-right coalition, but a PD-Lega marriage is very unlikely.

In the meantime the market reaction has been lukewarm. MIB futures were down 2% but recovered on market opening to lose only around 75bps. In government bonds, the 10 year BTP is down about 20 cents, leaving the BTP-Bund spread at +135bp, whilst the euro is overall stable against the Dollar.

In terms of “what next?”, nothing will really happen until the end of March anyway but, taking a look what the possible new government of the country could look like, particular focus should be placed on the role of the ministry of finance: 5 Star indicated Andrea Roventini as their candidate, an academic, strongly against leaving the euro but with a stance leaning towards considering all austerity measures bad for the economy as a whole. An even darker scenario is if the Lega will ask for that seat to form a coalition; their candidates Borghi and Bagnai are the strongest anti-euro campaigners in the country. Keep an eye on who will take the keys of the Treasury and hope that 5 Star will make a market friendly choice as their coalition partners. In the medium term the picture is very uncertain and it’s difficult to predict the final outcome but for the moment our view is for a relatively uneventful week on the markets until the parties shed some more light on what the way forward will be.

However, for market participants who were hoping for an election result that would trigger a re-rating of Italian assets, this has not happened and it will take time or a fresh catalyst to trigger this. BTP yields at flat to Portugal’s does not make fundamental sense, but for now this is where they are and will remain in the near term.