What is happening?
Populist winds in Europe may be abating, but Italy remains the one European country where anti-establishment and anti-euro parties still pose a significant risk. The constitutional court decided in January that there should be no second round in elections to the lower house of the Italian parliament. A party gaining 40% of the vote in the first and now only round would still be awarded a majority of the seats though. The removal of the second round of voting has reduced the risk that any antieuro party will be able to govern Italy alone after the elections, as no party is currently polling close to 40%. However, while the risk of an anti-euro government is not the most likely outcome, the risk has not been completely removed.
In March, the former ruling party, the Partito Democratico (PD), decided to split into two, with the anti-reform extreme left wing of the party creating a new progressive, democratic movement. In the short term, the split has weakened the PD and increased the power of the main anti-establishment party, the Movimento 5 Stella (M5S). The PD and M5S have been running neck andneck, with each commanding around 30% in the polls, but lately the pendulum has swung slightly in favour of M5S.
However, the split could pave the way for former prime minister, Matteo Renzi, to regain leadership of the party in May, with a victory potentially giving him a fresh opportunity to re-launch the PD with a renewed focus on reform and innovation.
Italy must hold a general election by May 2018, and M5S has called for a vote as soon as possible in order to take advantage of its positive position. However, the president, Sergio Mattarella, is against early elections under the current system, which elects members to the Senate and the Lower House using slightly different rules, and there is little sign that the parliament will agree legislation in the short term to give both chambers the same system.
Against this backdrop, the government of Paolo Gentiloni, who replaced Renzi as prime minister after the failed constitutional referendum in late 2016, is proving unexpectedly resilient. Gentiloni still has sufficient support in the Senate and the House to drive the current coalition to the natural end of the legislature in the spring of 2018.
Key issues and implications for investors
Italy remains a key area of political concern for Europe and is the only large country in the eurozone where popular support for membership in the single currency is below 50%2. Early elections cannot be excluded, and the reality is that only one of the country's four leading political parties is an active supporter of Italy remaining in the eurozone.
However, investors should weigh these concerns against some compensating positives. Early elections in Italy are still unlikely, particularly given lack of progress on the approval of a new, single electoral law for the two chambers of Parliament.
When elections do occur, it is not the most likely outcome that the anti-establishment M5S would win an outright victory. It is also unlikely that M5S would be able to form a coalition government, given the ideological obstacles it would face forming a coalition with either Lega Nord or Forza Italia, the other parties that are either tepid or hostile towards the euro.
Under Renzi's renewed leadership, the PD is likely to become a more centrist and reformist movement. This could attract some of the voters that were previously in favour of other centrist parties like Forza Italia, which is still in search of a new identity and a more solid leadership.
For better or worse, the next election in Italy is likely to increase the fragmentation of Italian politics. This is not helpful from an investment standpoint, since it would make important reforms more difficult and continued political uncertainty more likely. However, it should also make it much harder for any single party to take the country out of the eurozone.
For Italy, leaving the eurozone would also mean leaving the European Union, and that would require major constitutional reform-something that a weak coalition government might struggle to push through. In fact, leaving Europe has featured less prominently in M5S rhetoric in recent months.
Spreads between 10-year Italian bonds and German bunds remain higher vs. Spanish bonds, although they have fallen since the French presidential elections, in line with other European countries. However, the Italian equity market has been one of the eurozone�s best performing markets this year, second only to Spain. Investors appear, probably correctly, to place a relatively low probability on Italy calling a referendum on leaving the euro.