Italian populism unnerves investors in the eurozone

Europe’s investment community has barely had time to breathe a sigh of relief following Emmanuel Macron’s victory in the French presidential elections before starting to fret about other latent threats to the eurozone.

Some investors have hailed the election — in which Mr Macron, a pro-EU liberal defeated Marine Le Pen, the Eurosceptic rightwing candidate — as a sign that Europe’s economic recovery remains on track.

This follows the defeat of anti-EU candidates in both the Netherlands and Austria over the past six months, which also alleviated fears that a rise in populism across Europe could spark a break-up of the eurozone.

But many of Europe’s largest investors are now turning their attention to another risk to their portfolios that is rapidly gaining momentum: the rise of Italy’s Five Star Movement, and its potential to upend the economic bloc.

The concern is that Five Star, the anti-establishment party set up in 2009 by Beppe Grillo, the Italian comedian and blogger, could win the country’s next election, which is due to take place within 12 months.

Mujtaba Rahman, managing director at Eurasia Group, a consultancy that advises large investors on political risks, says: “The biggest risk in Europe is Italy. The euro area is not working and as long as it fails to deliver growth, populism will continue to grow.

“[Italy has] corruption problems, fiscal problems, banking sector problems, a refugee crisis, the government in power has not been elected and the prime minister has no political mandate. This is a recipe for a big crisis in Italy, which we are very concerned about. Our view for now is Five Star will win the election next year.”

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Recent polls have indicated Five Star is the most popular party in Italy, with the support of at least 32 per cent of the electorate, compared with 26 per cent for PD, the ruling centre-left democratic party.

Although most large investors recognise that Five Star’s political agenda remains unclear, they are concerned by the movement’s promise to hold a referendum on euro membership.

Philip Poole, global head of research at Deutsche Asset Management, Europe’s third-largest investment house, says: “Has the risk [to eurozone stability] entirely passed? It hasn’t, because the Italian elections are coming up, and Five Star is doing extremely well in the polls. Here you have the potential for an anti-EU coalition to be formed. The market has not really focused on this yet.”

Nicholette MacDonald-Brown, European equities fund manager at Schroders, the UK’s largest listed fund company, adds: “In political terms, [Italy] has to be the next big risk on the horizon.”

With public discontent on the rise about the country’s economic difficulties, banking crisis and high unemployment rate, there is widespread concern that the Italian population will choose to abandon the single currency, triggering an unprecedented political and economic crisis across the eurozone.

Such fears are particularly acute given that Italian public support for the euro is low compared with elsewhere in Europe. Just 53 per cent of the population supports the currency, according to a European Commission study carried out in the autumn of last year.

A strategist at one of the world’s largest hedge fund companies, speaking on condition on anonymity, says: “My base case in Italy is that some form of populist movement will be in power after the next election. Industrial production completely collapsed under the euro — it has been absolutely butchered. This has led to the slow rotting of a historically great economy. Italians know it — they’re not stupid.

Industrial production completely collapsed under the euro — it has been absolutely butchered. This has led to the slow rotting of a historically great economy

“A high-probability scenario is that Five Star gets in, they call a referendum on the euro within six months, and it results in a euro exit from Italy. That’s the beginning of the end of the euro. The implications for financial markets are absolutely profound. How do you reprice all of those assets?”

Other investors are hopeful that Matteo Renzi, Italy’s former prime minister who was forced to resign last December after losing a referendum on constitutional reforms, will claw back support. He successfully recaptured the leadership of the PD earlier this month.

Mr Renzi won more than 70 per cent of the ballots cast by 2m party supporters, alleviating concerns that the referendum loss had left him discredited.

Ewen Cameron Watt, chief investment strategist at BlackRock, the world’s largest asset manager, is optimistic that Italians will opt to continue using the single currency when given the choice. “What we have seen so far with the euro — whether with Cyprus or Greece — is that people choose the currency over sovereignty as their wealth is denominated in the currency,” he says.

“As Italy is so much more important to the eurozone project, [any] referendum [on the euro] will cause market palpitations. One would be an idiot not to recognise that. But so far people have voted for their pocket books, not for their ideals.”

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Others are less convinced. Nicholas Brooks, head of economic research at Intermediate Capital Group, the UK-listed asset manager, says that according to polls, just under 50 per cent of Italians support parties with Eurosceptic platforms. “Italy is a crucial risk,” he says.

Monica Defend, head of asset allocation research at Pioneer, one of Italy’s largest fund companies, adds that Mr Renzi’s political comeback is unlikely to curb the groundswell of support for Five Star. The electoral system in Italy has also set the bar lower than elsewhere in Europe for an extremist party to come to power, she says.

Ms Defend, whose team oversees €106bn of assets, says: “It seems reasonable to [assume that] the PD and the Five Star Movement will be neck and neck [in the election next year]. If we went into an election today, [the current system] would strongly favour the Five Star Movement.

“What we would really like to see is a government that will endorse the eurozone project further.”

Amid growing nervousness about Italy’s political prospects, many of Europe’s largest investment houses are avoiding the country altogether. Pioneer’s asset allocation team and the absolute return team at Jupiter, the UK fund company, have zero exposure to Italy.

Lucy MacDonald, chief investment officer for global equities at Allianz Global Investors, the German fund house that oversees €480bn of assets, similarly says her investment team has no Italian holdings.

“Investors are absolutely right to focus on Italy. It has weak growth, a very weak banking system and a very difficult political backdrop,” she says, adding that these concerns are affecting asset prices elsewhere in Europe.

“The overall impact of instability in a country of that size you cannot ignore. We need to look at that when assessing euro-area strength or weakness. Although the underlying economic picture [across Europe] is stronger, the existence of this threat in a large part of the euro area will keep a bit of a ceiling on [eurozone asset prices].”

Deutsche Asset Management has an overweight position on Italian government debt, although Mr Poole says this holding is likely to be “reappraised” as the election edges nearer.

“The election is still potentially a year away, so it is not something we would use at this stage to position funds. But a Five Star victory would clearly be negative [for eurozone asset prices]. For sure, if that happened, it would be very negative for peripheral bond spreads, for eurozone equities, and in particular for the euro.”

German election: ‘A bit of a non-event’

European asset managers’ conviction that Italian politics poses the gravest risk to the eurozone is matched only by their certainty that German parliamentary election this September carries next to no threat for investors.

“It is a little bit of a non-event,” said Wolfgang Kuhn, head of pan-European fixed income at Aberdeen Asset Management. “It will be business as usual.”

The national Bundestag election will potentially upend Chancellor Angela Merkel’s Christian Democratic Union-led bloc.

Ms Merkel, who has headed Europe’s biggest economy since 2005, is being challenged by Martin Schulz, a former president of the European Parliament. He staged a comeback to German politics at the beginning of the year when he replaced Sigmar Gabriel as leader of the centre-left Social Democrats.

Critically for those exposed to Germany, there is no binary risk as was the case in the French presidential election, where voters faced a stark choice between a pro- and an anti-EU candidate. Last month Mr Schulz signalled there would be no big change in Berlin’s pro-austerity stance on the eurozone, an approach that emphasises debt reduction and structural reform, if he became chancellor.

“Germany provides us with a lower-risk election,” says Stephanie Kelly, a political economist at Standard Life, the UK asset manager. “Investors are familiar with Ms Merkel and consider her a figurehead, so naturally [there is] nervousness, but Mr Schulz is very embedded in the European project.”

But he has a tough fight on his hands. Earlier this month his party suffered a shock regional election defeat and it is flagging in the polls, hurting his chances of unseating Ms Merkel.

Jennifer Thompson

Via FT