Political risk is intensifying in the Eurozone, specifically in France and Italy. In France, market jitters reflect recent turns in the run-up to the presidential election this year, but Italy is emerging as a potential auxiliary source of risk.
The first round of the French election takes place on April 23, and if no candidate persuades the majority, there will be a second round on May 7. That goes a long way in explaining why the VSTOXX futures show speculators betting on volatility in European equities from April onwards.
France is no stranger to Euroscepticism, and now political risk is intensifying, because the odds of seeing Marine Le Pen win the presidency are – if still small – somewhat more probable. Le Pen’s camp is cheering, because the center-right candidate, François Fillon, was found to have shown remarkably poor judgment in hiring his wife on generous terms with no tangible result to show for it, and yet is running as “the honest man in French politics”. At first, Fillon seemed like the moderates’ knight in shining armour – now he looks much less appealing to an electorate, which has no patience for shenanigans. A large part of Le Pen’s agenda is anti-immigration and anti-EU, but she also taps into the rising feeling of resentment towards a (perceived) pampered, corrupt and cosseted political elite with none of the headaches of regular folks. Bond markets are eyeing the upcoming election, expecting turmoil, as Madame “Frexit” Le Pen inches up in polls.
Underperformance (Exhibit 1) for French bonds and an increasing country-specific regression residual (Exhibit 2) show rising worry of her ambitions of an EU referendum and reintroduction of the franc.
Source: Goldman Sachs as shown on Seeking Alpha
This is where the spotlight moves to Italy. Italy has its own version of a populist, anti-EU/-immigration party in the Five Star Movement, headed by comedian-turned-politician Beppe Grillo. What is more, Italy – like France – could face an election this year after Matteo Renzi resigned in December, and economic fundamentals are dire. Growth is sluggish and the Italian debt-to-GDP ratio is at 133%. If the Five Star Movement comes closer to power, or if the government fails to attain a strong majority in Parliament that permits it to implement sweeping structural reforms, Italy could be in for some rough patches, ultimately putting pressure on its European membership.
The probability of an Italian election is known to trigger sell-off in Italian government bonds (BTPs); hence, the rising spread could be just a temporary market reaction to an expected upcoming political event (see chart). However, as with France, the question is whether the spread is going to diminish after the election, or if that will mark the point where spreads soar.
Note: Btp bund denotes the Italian/German spread and Oat bund denotes the French/German spread.
Source: Italy 24
Aside from political uncertainty, Italy and Italian bondholders should worry about tapering and a return to inflation. Because the economies of the Eurozone are far from aligned, the risks of inflationary pressures are just as heterogeneous and uneven as those of deflation. Italy has seen its 10-year borrowing cost double since June as markets adjust to post-QE realities. It works like a monetary tightening, making borrowing more costly for firms and households as well as the state. Arguably, the last thing low-growth, deflationary and indebted Italy needs right now is tighter monetary policy. It could put a lot of upwards pressure on Italian sovereign bond yields.
As rates go up, Italian government bondholders take losses on their holdings. A large chunk of these bonds is on the books of Italian banks. The Italian banking sector is not in good shape as is, and non-performing loans still weigh it down. EU’s article 32 determines that a state bailout is only possible if private equity and bondholder bail-in the bank before taxpayer funds are spent saving it. Many Italian pensioners own banking shares or bonds; that makes the banking crisis a politically charged issue as well. Parliament approved a €20.8bn bailout package in December, but this likely falls short of what is needed. In addition to the world’s oldest bank – Banca Monte dei Paschi di Siena, which remains problematic – other troublesome banks emerge in other regions, calling for more emergency funds.
Several factors – looming elections in France and maybe Italy too, upcoming ECB tapering and the end of loose monetary policy, high debt and ailing banks – explain why Italy might be the next Eurosceptic troublemaker. If France follows Le Pen along a populist, anti-EU trail, Italy could be next. An immediate impact in markets would likely reflect this probability.