A Guide to What Italy’s Election Will Mean for Financial Markets

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(Bloomberg) – Mario Draghi has brought some confidence to struggling Italian markets after becoming prime minister in February 2021, pushing ahead with reforms and building a strong relationship with Brussels. His imminent exit adds to a growing list of domestic asset concerns.

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A right-wing coalition is widely expected to win Italy’s elections on Sunday, adding fresh uncertainty to investors already worried about rising interest rates, an energy crisis and a possible recession. Such an outcome could cast doubt on the path of reforms, which are a condition for the country receiving European Union funds to speed up its recovery from the pandemic.

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“We expect increased volatility in the Italian equity market, albeit without extreme spikes before the September 25 vote and in the days immediately following,” said Fabio Caldato, Partner at Olympia Wealth Management. “Our concern applies to the medium term: the next government is facing a difficult autumn, social tensions are likely.”

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According to Ipek Ozkardeskaya, senior analyst at Swissquote, political risks will weigh on Italian bond markets as any widening of the yield spread between Italy and Germany will potentially weigh on the euro, “which generally bodes ill for European equities this year”.

So far, markets have been relatively bullish on election risk, with far-right leaders softening their tone during the campaign. Giorgia Meloni, believed to be Italy’s next prime minister, has spoken out in favor of constructive cooperation with Brussels.

Erik F. Nielsen, UniCredit Group’s chief economics advisor, is optimistic that Draghi’s sweeping reform program will be implemented, which would be “good news” for the country’s financial markets.

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However, with the appointment of a cabinet expected to come at the end of next month at the earliest, the main test of the new government will likely have to wait a while longer, according to economist Sven Jari Stehn of Goldman Sachs Group Inc.

The appointment of ministers, particularly for the finance role, will be crucial for markets eager for a reliable number to manage an economy historically burdened by high levels of debt.

Here’s a recap of sectors to watch ahead of the election:

finance

Lenders like Intesa Sanpaolo SpA and UniCredit SpA are sensitive to the spread between Italian bonds, known as BTPs, and German Bunds, which could react to the outcome of the vote. Rising yields could weigh on financials, which make up nearly 30% of the FTSE MIB Index. The additional yield that investors demand to hold Italian 10-year notes versus German debt is 25 basis points higher since July 19, the day before Draghi announced his retirement.

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Despite the current macroeconomic challenges, after years of painful restructuring, Italian banks are in better shape compared to previous crises. And the country’s lenders, along with European peers, could benefit from higher interest rates boosting net interest income in the coming months.

Banca Monte dei Paschi di Siena SpA’s planned capital increase will also be a focus as the lender seeks to raise new equity and shed around 4,000 jobs as part of a plan to increase capital reserves and profitability.

Utilities, Energy

The two sub-groups have a combined weight of around 28% in the FTSE-MIB, potentially making the benchmark sensitive to actions taken at local or EU level to counter rising energy prices. In May, Italy increased its windfall tax on energy industry profits from 10% to 25%, with Eni SpA saying it would pay a special tax of about 1.4 billion euros ($1.4 billion).

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Meloni has hinted that a government she leads would take unilateral action to decouple electricity costs from gas prices if the EU doesn’t make quick progress on a joint effort. Last week the European Commission unveiled a radical intervention plan, but member states, which have to agree to the proposals, are still at odds over the details.

READ: Salvini plans $30 billion in energy subsidies to help Italian businesses

State Controlled Companies

Leadership announcements at state-controlled companies, several of which are large caps on the Milan Stock Exchange, are due in the spring. The focus of the new cabinet is on the top positions at Enel SpA, Eni, Terna SpA, Poste Italiane SpA and Leonardo SpA.

“A government led by Meloni could have more invasive effects on the economy and on state-controlled companies,” including with regard to the so-called Golden Power scheme to protect strategic assets, said Matteo Brancolini, fund manager at BPER Banca in Milan.

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Telecom Italy

Italy’s state-backed lender is likely to make its bid for Telecom Italia SpA’s network after the elections, Bloomberg News reported this month. Draghi’s government has been discussing for months a possible merger between the former phone monopoly’s ultra-broadband network and its smaller, state-backed rival Open Fiber SpA.

Separately, Meloni’s Brothers of Italy are promoting a plan to privatize Telecom Italia and sell the phone company’s assets to reduce the debt mountain by more than half, people familiar with the matter said last month.

Bind

The gap between Italian and German 10-year bond yields has been relatively stable in recent weeks, below its high for the year, reflecting pledges by right-wing coalition members to stick to the country’s plan to spend EU recovery money.

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But investors and strategists have warned against complacency, saying Italy’s spread could surpass a year-high of 244 basis points if, as expected, Allianz takes power. On Tuesday it was around 227 basis points.

recognition

Spreads for high-quality Italian corporate debt are at higher levels than they were at the last national election in 2018, according to a Bloomberg index.

While this is partly due to the environment of rising interest rates, credit risk increased sharply over the course of 2022, particularly for Italy. The spread differential between Italian corporate issuers and their European peers is the widest in two years according to credit strategist Mahesh Bhimalingam, according to Bloomberg Intelligence Chief European.

Italian credit spreads appear “already heavily discounted from the experience of 2018,” said Bank of America Corp. strategists including Barnaby Martin and Ioannis Angelakis. “The risk of political uncertainty is that Italy returns to a low-productivity, low-growth economy,” they wrote in a note, “repeating concerns about debt sustainability.”