Nothing gets strategists buzzing quite like a potentially close election. True to form, they’ve been serving up heaps of forecasts ahead of Italy’s big vote on Sunday.
Full results for the general election in the euro zone’s third-largest economy are due Monday, though exit polls could signal Sunday how it all turned out.
There are five possible outcomes, reckons Silvia Dall’Angelo, a senior economist at Hermes Investment Management: (1.) Political gridlock followed by another election; (2.) a victory for a center-right alliance of parties; (3.) a center-left coalition government; (4.) a government led by the antiestablishment 5 Star Movement; or (5.) a grand coalition. Each has an anticipated impact on European stocks.
“Markets are dismissing an election shock. But this complacency may not last,” Dall’Angelo writes in a recent note. At the same time, she stresses, Italy is accustomed to political instability, with 65 administrations since World War II, “each one lasting for a little more than a year on average.”
Check out: Italian general election — when are the results out?
The worst-case scenario for stocks
The worst-case scenario for equity markets—mostly Italy’s—would be an anti-euro coalition government comprised of the 5 Star Movement and the populist Northern League and Brothers of Italy parties, says Seema Shah, an investment strategist at Principal Global Investors. She views that outcome as a remote possibility, and she emphasizes the recent shifts by the 5 Star Movement.
“There has been a lot of focus from international media on the fact that the 5 Star Movement has been anti-euro and they may be calling for an exit from the European Union,” Shah tells Barron’s. “What we’ve seen in the last few months is they have backed away quite significantly from that standpoint.”
If the party wins, “the selloff would be considerably smaller than it would have been last year,” she adds.
Oxford Economics analysts aren’t as sanguine, though they give no more than a “one in 20 chance of a populist-led coalition government.” The advisory firm’s Jamie Thomson and Nicola Nobile offer this warning in a recent note: “Even an Italian populist government’s failed attempt to ditch the EURUSD, +0.4320% could bring a halt to not only the ‘euroboom,’ but also the process of U.S. monetary normalization, with the market reaction comparable to the euro-zone debt crisis.”
Read more: Here’s one thing that could ruin the “euroboom”
The best-case scenario for stocks
Traders may put on their rally caps if a grand coalition starts to look likely, but they might have to wait longer for that outcome. “You’re not likely to have that result clear on Monday morning,” Shah says. “Fast-forward two or three weeks, and you get to the point that there is a grand coalition, that is when you would see a relief rally.”
This scenario refers to a broad coalition that involves center-left parties such as Prime Minister Paolo Gentiloni’s Democratic Party, as well as parts of the center-right alliance such as media tycoon Silvio Berlusconi’s Forza Italia party. “It is deemed the most market-friendly outcome, as it would result in the continuation of current policies,” says Dall’Angelo.
The most likely scenario
The most likely outcome is some sort of coalition government with a weak mandate, according to Dall’Angelo and other election watchers. Scenarios 1, 2, and 3 mentioned above each could deliver that—at least eventually. The final opinion polls released in mid-February, before a blackout on such surveys, showed the center-right alliance in the lead but not with a working majority, signaling gridlock. Strategists suggest markets can live with this type of outcome.
“Difficult post-election negotiations are the norm nowadays, as seen with the prolonged attempt to form a government in Germany,” wrote Konstantinos Anthis, head of research at ADS Securities, in an email to Barron’s.
Italy’s FTSE MIB benchmark I945, -2.39% has fared better than other European equity SXXP, -2.09% in 2018, recently showing a year-to-date advance of less than 1%. “The outperformance has just been people catching up to, ‘OK, the actual Italian election isn’t as dangerous as had it taken place last year,’” says Shah.
Investors may want to favor Italian stocks that both will weather a shock outcome better than the broad market, and also ought to see gains as the dust settles, wrote UBS analysts in a recent note. The Swiss bank’s analysts recommend Italian companies that aren’t as exposed to the domestic economy, big-cap stocks that are generally more resilient, banks that would benefit from rising interest rates, and companies with strong balance sheets.
Their picks include eyeglasses juggernaut Luxottica Group LUX, -0.62% , cellphone tower giant Infrastrutture Wireless Italiane INW, -2.61% , utility Enel ENEL, -2.20% , energy firm ENI, -1.43% and a couple of banks, Intesa Sanpaolo ISP, -2.16% and Banco BPM BAMI, -2.14% .
Read more: UBS gives stocks to buy and avoid as Italy votes
Investors also might want to keep an eye on how another key European vote turns out. Germany’s Social Democrats are due to reveal Sunday whether party members support joining a new coalition government with Chancellor Angela Merkel’s conservative bloc.
Don’t miss: Sunday could determine the political future of Germany and Italy
And see: Hedge funds’ faith in euro dwindles ahead of political ‘Super Sunday’
This story first appeared at Barrons.com.