Why financial markets have taken Italian election in their stride

5 March 2018, 13:18

The Italian elections have delivered fresh uncertainty to the eurozone.

The region's third largest economy now faces a protracted period during which the composition of its next government remains uncertain.

Yet the market turmoil that had been expected in the event of a hung parliament has not materialised.

The MIB, the main Italian stock index, was down 2% at the open to hit its lowest point for six months but has since clawed its way back to show only a modest loss on the session.

Italian government bonds, meanwhile, suffered a small sell-off but not an aggressive one. The yield - which rises as prices fall - on Italian 10-year bonds, which was 2.04% on Friday evening, briefly hit 2.128% before stabilising at around 2.11% again, hardly an indication of a massive loss of confidence among investors.

So what's going on?

Well, largely, the lack of a violent market reaction reflects the fact that this is precisely the outcome investors had expected.

Moreover, the election result does not change the outlook for the fundamentals of the Italian economy.

None of the parties that were expected to form a government - the centre right bloc led by Silvio Berlusconi's Forza Italia or the anti-establishment 5-Star Movement, founded by the comedian Beppe Grillo, are promising to fix Italy's public debt which, at 131.5% of GDP, is among the highest in the world and one of the main drags on the economy.

In fact, the outgoing government headed by the centre left Democratic Party had been making reasonable progress. The overall debt-to-GDP ratio actually fell slightly during 2017 while the deficit-to-GDP ratio, at 1.9%, is also down.

There were no promises from any other parties vying to out-do the outgoing government in terms of deficit reduction - so it is not as if the election of a hung parliament is going to be a crashing disappointment to investors on that front.

And any concerns over a threat to the stability of the eurozone posed by an inconclusive Italian election result will also have been tempered by news over the weekend that a coalition government in Germany has been formally signed off by Chancellor Angela Merkel's coalition partners.

Yes, the populist 5-Star Movement, the biggest single party following the election, is likely to be pivotal to any negotiations for a new coalition government. But even it has admitted that the time has passed for its long-standing demand for Italy to leave the euro area.

That is not to say markets could not take a wobble in future. Any indication that the 5-Star Movement were to participate in the next government would clearly be perceived as a negative by the market.

But the most likely outcome, to judge by the results, is that the centre right bloc could just about form a government with some support of a few MPs from elsewhere.

As Fabio Fois, analyst at Barclays, noted today: "Under this scenario, we would expect financial markets to react positively, at least in the near term."

In the meantime, as investors wait for the coalition negotiations to start, they will also have in mind a number of economic fundamentals.

The 1.5% by which Italian GDP grew last year is nothing to write home about in comparison with other major economies, but in the light of where the Italian economy has been during the last decade (Italy is one of only a handful of EU economies which remains smaller than it was before the global financial crisis), it represents progress of a sort.

If the deficit-to-GDP ratio continues to fall, it may even stimulate demand for Italian government debt. And even the banking sector, one of the major causes for concern in recent years, is on a more stable footing than it was.

To be sure, there are still lots of things that could go badly wrong for Italy. But, for now, investors are taking the clear-eyed decision that that time has not yet arrived.