Over the last few days there have been three significant events in European politics: the much anticipated Italian elections; the agreement on a new Grand Coalition in Germany; and the UK Prime Minister giving a major key note speech on Brexit that has been widely interpreted as providing greater clarity on what the UK would like a final deal with the EU to look like.
All three of these events matter for the market. The initial impact has been relatively muted, although it was always possible the markets could have reacted badly to different outcomes, particularly in Germany and the UK. Also, this market reaction may be because it is only in coming months that developments in each country, in their own way, have important consequences as they set a future direction of travel for policy.
Italian Election Outcome
Let’s consider the consequences of each. First, Italy, as that has the potential to have the biggest immediate impact. Post war Italian politics was always seen in terms of shaky coalitions, frequent changes in Government and a host of different Prime Ministers. Since the beginning of this century for instance Italy has seen the following PMs: Massimo D’Alema, Giulaino Amato, Silvio Berlusconi who served two successive terms form June 2001 to May 2006, Romano Prodi, Berlusconi again, then the bizarre case of the EU instructing the Italians to install a technocrat Mario Monti as Prime Minister, from 2011-13, followed in recent years by Enrio Letta, Matteo Renzi and Paolo Gentiloni. Perhaps therefore it is no surprise that the latest elections on Sunday have led to an unclear outcome, with no individual party receiving enough votes to govern the country standalone. What they do show though is that euro scepticism is high: the populist 5 Star Movement was the biggest single party, and the right of centre coalition was the largest combined grouping. All in all 55% of Italians voted in support of euro sceptic, anti-establishment parties. Immigration and youth unemployment were the two main issues. Both reflect concern about wider EU policy and the impact on Italy.
The euro has been at the root of Italy’s problems over the last few decades. Since the global financial crisis a decade ago, Italy’s economy has effectively flat-lined, in terms of economic growth and the level of employment. Meanwhile migration has seen the population rise. Unable to benefit from a currency devaluation Italy has suffered from a squeeze on the domestic economy, with an underperformance of the south of the country versus the north and also has witnessed a poor national performance versus Northern Europe, led by Germany.
Italy is the third largest euro zone economy, with a huge bond market, largely domestically owned. According to the European Central Bank (ECB), the size of the Italian central government bond market is €1.88 trillion, versus €1.67 trillion in France and €1.18 trillion in Germany. It is the ability to service its debt and the contagion that events in Italy may cause elsewhere in the euro area that often are the focus of the market’s attention, however recent movements in Italian bond yields have been subdued and the yield spread above German bunds remains contained. Additionally, the recent rebound in the euro area economy, thanks to the ECB’s monetary policy has provided welcome relief. Equity markets are also indicating that as things stand the results are primarily a domestic Italian issue, with the Italian FTSE MIB index marginally underperforming major European bourses in the aftermath of the election. However, it is worth noting that the Italian stock index has been the best performing developed European market on a year to date basis. The markets will be closely watching ECB policy, as the longer it remains stimulatory the better it is for Italy. The election outcome in Italy may not result immediately in a change in economic policy as Italy is not threatening to leave the euro, but it could lead to a more euro sceptic government in Rome and to immigration becoming an even more central policy issue across the EU.
German Coalition Agreement
That leads directly to the German situation. The markets will be relieved that after five months Germany has a functioning government after the formation of a CDU-SPD Grand Coalition. While such stability is welcome, the last few months have led to questions about Merkel’s leadership. A wider concern is also that the AfD may gather in strength as the de-facto opposition in Germany. How this plays out in terms of immediate policy in Europe remains to be seen. The Germans, also, it has been said, are keen to assume the leadership of the ECB when the current position of President Draghi becomes vacant in autumn 2019. Domestically, the SPD has taken control of a host of senior ministries. Whether there is a trade-off between their need to address domestic issues versus wider EU concerns will be a focus for the markets. One issue, in particular, is how much support Germany will give to the federalist structure for the EU that President Macron is keen to push. Although the direct intention of this may not help Italy, it would lead to a significant shift in policy with the combination of a more relaxed fiscal stance from German and the need for more reform in France, Italy and elsewhere. For the markets the focus will be both on the near-term macro-economic implications as well as the longer-term policy shifts that may be needed. Both are welcome.
UK Brexit Update
Finally, there was Prime Minister May’s latest key note speech on Brexit. It was the culmination of what may prove a pivotal week in the Brexit debate. From the market’s perspective the proposal from the PM was pragmatic and credible. The key issue now is the response of the EU and whether they opt for being constructive or confrontational. The immediate test will be whether, as expected, agreement is reached soon on a transition or implementation phase. We will have to see over the next few weeks whether the politics falls into line with the economics, as the markets would like them to.