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Italians will head to the polls in the spring to elect their next government. Despite recent electoral reforms, Charlie Diebel explains why Italian uncertainty is unlikely to disappear.

The next Italian general election, expected to take place in the spring of 2018, has long been deemed a key event for financial markets. The rise of the anti-establishment Five-Star Movement, with its threats of holding a referendum on Italy's membership of the euro currency bloc should it be elected, has been seen as a risk to regional stability.

On October 26, the Italian parliament passed new electoral rules that could prove a pivotal moment in stopping Five-Star's momentum. Specifically, the reforms allow Italy's political parties to form alliances ahead of the election. By putting forward a single candidate for each electoral district, those alliances stand a better chance of negating the Five-Star challenge - which, to date, has steadfastly refused to join forces with another party. Five-Star claims the reforms could cost it 50 seats and has been organizing protests since the electoral reforms were passed by the lower house of parliament on 12 October.

Yet regardless of whether electoral reforms effectively halt the Five-Star challenge, a bigger question remains: is there a party or coalition that can deliver the sort of structural reforms Italy needs? Charlie Diebel, Global Head of Rates at Aviva Investors, believes this remains a major source of uncertainty.

Now that the electoral reforms have been passed, will markets see this as averting the prospect of an anti-Europe party ruling Italy?

Electoral reforms reduce the tail risk the Five Star movement comes into power and Italy leaves the European Union. But it does not necessarily bode terribly well for the longer-term structural reforms Italy needs to flourish.

If we end up with a grand coalition government, there will be some effort at reform. But one could argue Italy has made more progress when they have had technocratic governments. These governments can push change through, they can make all the nasty decisions that politicians don’t want to and there’s a benefit to the economy. A grand coalition, particularly if it is stable, does not really fill you with optimism that you are going to see a real push for reform.

Why are investors so jittery about Five Star’s popularity?

It is not Five Star per se; it is the populism running through politics that investors are worried about. We are seeing that in Catalonia; we’ve seen it in the UK, with Trump’s election in the US, and the surprising performance from the Alternative for Germany party in the recent elections. You could argue there is a generational battle going on between the older population and the disenfranchised younger and middle age demographic, whose longer-term prospects are deteriorating. There seems to be a fragmentation in the developed world, and people are almost becoming tribal; they are identifying with and looking out for a group rather than thinking about the greater good.

So you don’t see a solution necessarily?

Normally one expects people will be quite positive in times of economic recovery. And yet, taking the US example, a non-conformist president has been voted in during a period when the country has been on a gradual but prolonged period of economic expansion. The UK, up until the Brexit vote, had been improving economically. Even Europe is doing well now, so why is there a dissatisfaction vote when at least from an economic point of view, times are good?

One possible cause is that the rising tide is not lifting all boats. It feels quite unstable at this point in time and, as far as markets are concerned, it fosters uncertainty. Let’s look at Mexico: from a relatively benign environment when emerging markets were rallying sharply, suddenly there was idiosyncratic risk appearing in numerous places. The future of the North American Free Trade Agreement was a cause for concern, Mexico sold off sharply, and then after some good news Mexico rallied. There’s a lack of conviction in trading, which is becoming very headline driven.

Going back to Italy, Five Star has tapped into the dissatisfaction. Even with the new electoral laws, it begs the question: will Five Star morph into something people look to coalesce around again?

Five Star is currently trending at around 30 per cent in the polls, could they gain another 10-15 points and become the majority party?

This is exactly what markets are worried about. Arguably the UK right now would be better off if the government had said there will be a hard Brexit, because at least you would know what to plan for. At this point in Italian politics, it’s difficult to see what we are going to get. What kind of political structure; how long will it last; will it push through some reforms? If it’s a grand coalition that’s a possibility, but it does not exactly foster certainty.

What is the likelihood of Five Star going back on their original pledge to not enter into a coalition?

It will be interesting to see how much of the protest vote embedded in Five Star tries to find a home somewhere else if electors feel that their vote is wasted. It is like holding a ball under water; one way or another that ball wants to get to the surface.  

As we saw in the US, when Sanders voters shifted allegiance to Trump?

That is an interesting possibility; but again, hard to quantify. The hope is that as long as growth remains relatively positive, you have to question whether the electorate are really going to vote for massive change.  

A potential coalition between the Democrats and Silvio Berlusconi’s Forza Italia has been touted. Although Berlusconi could not officially take a fourth term due to his conviction for tax fraud, one of his lieutenants could. How would investors view this?

That would be a more right-wing coalition. So it would probably be more pro-market, but not necessarily more pro-reform. Berlusconi was not terribly efficient in getting reforms through. Although stable, I am not sure if structural reforms would be at the top of their list.

You’ve said previously that the “potential havoc the Italian election could wreak has always made it the biggest of the [European] elections”. Does the reform of the election process change your view?

It has lowered the chance that it wreaks havoc, but it still could. There are a lot of divisive elements within Europe, and by divisive I mean separatist. Italy is a major founding member of the euro. If its political structure contains EU separatists, it becomes a much more viable and potential real threat. It is not a small country that could be exited without duress particularly.

Once the election is called, do you think markets will really start to focus on Italy?

Investors will start to pay attention after Christmas. But with the number of parties and the possible coalitions, if they think Five Star is subdued, the tail risk is gone. If it looks even remotely possible that Five Star have a role to play, it becomes much more significant.

If Five Star forms an alliance with one of the right-wing fringe groups, do you then have a viable threat?

Until we are certain they do not pose a threat, Five Star will be a concern. If opinion polls are putting them into a scenario where they might be in power then markets are likely to remain nervous, even if from an economic point of view it would be madness for Italy.

Regardless of the election outcome, Italy seems to be somewhat of an outlier in an otherwise improving euro area economy. What’s at the core of its struggles and can you see that changing any time soon?

It’s the banking sector largely. Of all the European banking sectors, it is the one saddled with the most non-performing loans and excess leverage. This has stopped the credit channel from really opening up to support growth, like it has elsewhere, because Europe has a very bank-driven economic model. 

At the same time, the reform process in Italy has stalled. If you look at the scale of the welfare state, the labour laws, the lack of labour flexibility; there’s a lot of wood to chop in terms of the reforms. This is why it’s a laggard: it hasn’t removed the inefficiencies and the structural rigidities in the economy to help it grow and prosper in the longer term.

It could be argued electoral reform will worsen the political stalemate that afflicts Italy, rather than resolve it. Is that a fair assessment?

A stalemate that does not include Five Star in a grand coalition is a form of stability as far as markets are concerned. What it doesn’t do is make Italy an attractive place to invest. You are just removing the tail risk.

There are still so many uncertainties that nothing really inspires one to believe Italy is about to perform strongly. It is hard to see a political outcome that engenders the reform process and sets the country clearly on a better path. Most of the political scenarios we talk about now are more of a can-kicking exercise, unless Five Star gets into power. That would be a real shock to markets. 

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