Two major European political events fall on Sunday, March 4, leaving investors to brace for what a worst-case outcome could mean for European assets.
On that day, Italy goes to the polls in a national election, while Germany’s center-left Social Democratic Party announces the result of its vote to decide whether to join a grand coalition with Chancellor Angela Merkel and her center-right Christian Democratic Union. The outcome could set the tone for the continent’s currency and political landscape for the rest of the year.
A result that’s seen as increasing political turmoil could drag down the euro EURUSD, -0.3000% which has strengthened against its rivals over the past year. It could also drive government bond yields to jump, particularly in Europe’s most debt-burdened countries, such as Italy TMBMKIT-10Y, +0.76% For now, however, polls give analysts reason to be hopeful.
What’s going on in Italy?
Italians will decide between the left-leaning populist 5 Star Movement, which has taken the lead in polls, followed by the center-left Democratic Party and the center-right Forza Italia. The far-right Lega Nord and Brothers of Italy are trailing the others.
“In line with what happened in a lot other eurozone countries, Italy’s political landscape has become fragmented during the past few years,” said Aline Schuiling, senior economist for ABN Amro. “Consequently, it is possible that forming a new government turns out to be too complicated and a new election needs to be held.”
A hung parliament is seen as the most likely outcome, said SEB analysts including economist Daniel Bergvall, prescribing a 38% probability, given recent polls and a Bloomberg survey. It would also be the second-best option for EU relations, they said.
“A hung parliament will either prompt Forza Italia to join into a grand coalition with the Democratic Party,” said the SEB team — which prescribes a 33% chance to this outcome and calls it the best for the EU — “or a continuation of the current caretaker government.”
A win for the 5 Star Movement “is seen as the least favorable but also the least likely outcome” at 8%, the SEB analysts wrote. Five Star is no longer as anti-euro as it used to be, nonetheless there are some risks, especially as Italy’s economic growth is weaker than that of its peers and the Italian banking system remains full of bad debt, they said.
Also read: Here’s one thing that could ruin the ‘euroboom’
Indeed, Italy’s public finances are still a source of concern, and economists say a government led by the Democratic Party would likely be the most reassuring.
“Altogether, an anti-European Monetary Union/anti-Europe election outcome is unlikely,” the SEB analysts said. “However, a strongly pro-euro and Europe outcome is not likely, either. The political middle-ground outcome will be muddling through, which, in the context of strong EU growth, means marginally better economic and fiscal performance for Italy.”
What’s going on in Germany?
Germany’s Social Democrats have until March 2 to decide on whether the center-left party will enter into the grand coalition. The result will be announced on March 4.
“Markets have been uncertain whether SPD members would accept the deal,” wrote RBC’s global head of FX strategy Elsa Lignos. “Failure to do so could lead to a second election in Germany, with a fall in support for the SPD and an increase in votes for the [far right] Alternative for Germany, based on current polling.”
Germany held a general election in September, crowning incumbent Chancellor Angela Merkel as the winner amid historically poor support for both major parties.
Read: Here’s what Germany’s next finance minister could mean for the euro
Merkel has been unable to form a government since, as her CDU didn’t get enough votes for an outright majority. Negotiations fell through for a so-called Jamaica coalition (named after the party colors) between the CDU, the pro-business Free Democrats and the Green Party. That left Merkel to knock on the door of her party’s former partner, also the main opposition party — the SPD.
The SPD, in turn, initially said it was done governing with the center-right CDU, but eventually came to the negotiation table anyway, which caused an internal rift in the party. Since the beginning of the talks, the SPD registered a multitude of membership applications, according to local media reports, with new members now getting their say on the final outcome.
If this attempt at a coalition falls through, Merkel could either decide to form a minority government, which she previously spoke out against, or call new elections, which would likely rattle the euro and send tremors throughout the continent’s political scene.
That said, “last Friday a regional German paper published the first proper poll we have seen of SPD members showing 60% support for the coalition agreement,” Lignos wrote.