Sometimes, financial markets prove to be more efficient than you give them credit for. Take the muted reaction to Italy's parliamentary elections. By any reasonable standard, Italian voters have delivered quite a surprise. The anti-establishment Five Star Movement emerged as the largest party, as expected, with about 32% of the vote and looks set to capture at least a similar share of seats at the time of writing. That's far more than most observers had forecasted. It's a similar story for the far-right Lega. At about 18% of the vote share, Lega looks certain to emerge as the biggest parliamentary force in Silvio Berlusconi's center-right coalition. The populist gains came mainly at the expense of pretty much everyone else, including both Berslusconi's center-right Forza Italia (14%) and Matteo Renzi's center-left Democratic Party (19%). What, if any, government will emerge from these results remains anybody's guess, probably until well after all the votes have been counted and all seats have been declared. (A more or less final tally is expected at some point today, probably in the course of the afternoon.)
Taken together, Five Star and Lega have outperformed unadjusted polling averages by about 9%. In any other country, that would be very unusual. In Italy, it was just another polling error roughly in line with recent experience, as we previously argued "An Italian muddle" .
From a broader market perspective, the calm among investors so far is both reassuring and a touch worrying. The euro weakened only slightly against the dollar. Perhaps, this was because the Italian elections coincided with positive news that Germany will – finally – get a new government, again under Angela Merkel. After much nail-biting, Germany's Social Democrats voted with a surprisingly strong two-thirds majority to once again become junior partners in another grand coalition.
In equity markets, there were some declines in Asia overnight. This probably had more to do with fears over U.S. protectionism than Italian politics becoming even more fragmented. European market reactions were rather muted with only Italy showing signs of volatility, after having outperformed global markets since the start of the year . As for domestic demand, Italy's economic momentum continues to look strong. We expect Italian earnings growth to be well above Eurozone averages, but continued political uncertainty could increase downside risks.
In bond markets, we have seen moderate spread widening of Italian sovereign bonds compared to German bunds. Italian corporate bonds are likely to reverse some of their gains ahead of the elections. But, while we may continue to see some volatility, as election results continue to trickle in, we would not expect a dramatic and lasting reaction.
Italy, after all, did not suddenly become ungovernable – the elections merely reinforce previous trends. Nor was it ever especially likely that the new government would enact the sorts of reforms Italy continues to urgently need.
Take a step back, however, and there are risks both in the short and in the longer term. Much of the Five Star and Lega personnel are fairly new to the national political scene, which could create headline risks in coming days and weeks. The election results also reinforce longer-term worries. As in Italy's 2016 constitutional referendum, broadly centrist and euro-friendly forces have suffered another stunning defeat. That will make it no easier to reach a European consensus on measures eventually needed for the common currency and the European Union as a whole to function effectively.