Skip to the content

Assessing political risk In Italy

22 June 2017

James Ashley, head of international market strategy EMEA, Goldman Sachs Asset Management, considers how an Italian election might emerge as a source of disruption in the European political landscape.

By Ashley James,

Goldman Sachs Asset Management

The UK Conservative party’s surprise failure to secure a majority government at the snap general elections on 8 June, contrary to prior polling expectations, shows that political risk is alive and well in European markets.

Looking ahead, Italy is widely seen as the next potential source of disruption in the European political landscape.

Although our base case is that Italy’s political risks are manageable, the stakes are high enough that the low-probability, high-impact scenario of an Italian exit from the eurozone constitutes an outlier worth monitoring closely.

The next Italian general election is likely to take place in early 2018 and will be held no later than 20 May. Thus far, a deal to improve the country’s political system by reforming electoral laws has been elusive. The prospect of a snap national vote dimmed substantially now that the agreement for a new electoral law between Matteo Renzi, head of the centre-left Partito Democratico (Democratic Party, or PD), Beppe Grillo, head of the Eurosceptic, anti-establishment and anti-globalist Movimento Cinque Stelle (Five Star Movement, or M5S), and other main parties unexpectedly collapsed in parliament.

There are reasons to consider the “tails” of Italy’s political risk distribution to be fatter and thus potentially more significant than those in France or the UK.

For one, Italy’s Eurosceptic, anti-establishment M5S has grown quite popular. The party today constitutes one of the two biggest political forces in the country, together with Renzi’s Democratic Party, both with support around 29 per cent in recent polls. Although the first round of the Italian local election on 11 June showed a weakening momentum for M5S, the lack of dominance by any single party creates the possibility of an even more fractured landscape.

For instance, smaller parties like Silvio Berlusconi’s Forza Italia, or the anti-immigrant Northern League, may prove pivotal in the formation of the next government. We see a chance of a hung parliament once the 2018 ballot takes place, which could be negative for markets. Reduced governability and the correspondingly slimmer chances of comprehensive structural reforms point to the possibility of higher country risk, wider spreads and greater volatility.

Another reason Italian risk is more nuanced is the country’s disappointing long-run economic growth and high debt-to-GDP levels, which can be viewed as either cause or effect of the country’s unstable politics and rising euroscepticism.

Italy’s rating of Baa2 (with a negative outlook) is the lowest of the G7 economies and dangerously close to the “junk” category; its debt-to-GDP ratio of 133 per cent, as of 2016, exceeds both the median of similarly-rated countries as well as that of its euro area peers. Parts of the Italian banking sector remain undercapitalised. Non-performing loans remain high by EU standards, despite improvements in commercial banking and a rise in bank credit supply.

To be sure, a tail risk scenario of a referendum to leave the EU remains highly unlikely. The first step in such a direction would be a constitutional amendment authorising a rethink of international treaties, which is not currently possible.

Only after such an amendment would a truly systemic series of events be possible, which seems all the more remote in light of Italians’ vote with an ample majority just seven months ago that showed reluctance to change the constitutional status quo.

Even so, political risk in Italy and, to some degree, Europe more generally, can be likened to the probability of safely walking a narrow mountain pass. The base case is that we cross without incident, which is what will happen in the great majority of cases. But a slip of the foot on either side of the pass would be hugely consequential. We believe markets continue to underestimate political risk on both sides of the Atlantic.

Low-probability, high-consequence events are worth careful monitoring in today’s investment climate. They represent one of the key reasons we favour a flexible, dynamic approach to investing, one which is designed to adapt to climates of volatility.

James Ashley is head of international market strategy EMEA at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.