Political changes in Europe and impacts on the euro

Brothers of Italy (Fratelli d'Italia) leader Giorgia Meloni at an election campaign rally in Genoa last week.

There are huge amounts written about them and financial markets spend countless hours trawling over every word from the politicians and central bankers but, at the end of the day, their impact on currency direction is probably not as great as many would have us believe. If we are right about this, the looming Italian election should not pose a huge risk to the euro.

Not for the first time, it seems that there are investors out there that are fearing the worst should a far-right politician in the euro zone make it to power. In the past, these concerns have been largely related to Marine Le Pen who has tried, and failed, to become French president. Of course, concerns were much greater in the early days when she seemed intent on pulling France out of European Economic and Monetary Union (EMU). But even with these comments toned down there’s still been some trepidation amongst investors.

Today, the focus is on Italy as national elections on September 25^th look set to catapult Giorgia Meloni into the top spot. She would be the first far-right leader of Italy since the Second World War. Her Brothers of Italy party looks set not just to take over from Draghi’s unity government in conjunction with other right-of-centre parties, but their majority and constitutional problems in the country could give the new government a huge mandate to govern, which is something not always bestowed on incoming governments in the past.

In other words, if Meloni and her cohorts declared that they wanted to leave EMU they probably could. Perhaps it is fortunate, therefore, that she does not want to. But does that mean that there will be a seamless transition to the new government and no escalation in tensions with the EU?

Probably not. We have become used to seeing right-of-centre governments in Europe bicker with the EU, but these have largely been countries outside of EMU, such as Hungry and Poland. If Italy becomes a country like Hungary and Poland that clashes with the EU from the inside, the consequences could clearly be significant for Italy’s debt market and the euro. But Italy is in a weak position from an economic perspective with poor growth, high youth unemployment, high dependency on Russian gas, a huge debt burden and more.

It is hardly in a position to take on the EU and we suspect that this will mitigate any adverse financial market implications. Italy, like others is a recipient of large fiscal support from the EU via the Next Generation plan, which totals around EUR800bn in all. In addition, some would argue that the ECB’s recently announced anti-fragmentation tool for the euro zone bond market, the Transmission Protection Instrument (TPI) should really be called the To Protect Italy plan.

But while we might be able to downplay the risk that a sharp rightward shift in Italian politics does not threaten a new debt crisis or significant euro weakness, this does not mean that Italy is off the hook. The fundamentals of Italy’s current situation are the key and, as we mentioned above, they are not good. Should these begin to put real pressure on Italian financial assets and the euro, then that’s the point when having a far-right leader at the helm could prove troublesome.

For while some of the lashing out at these travails could occur in ways usually associated with far-right parties, such as immigration, the EU could be drawn into the firing line and, if that happens, it could compound financial market pressure.

The bottom line for us is that we don’t see next weekend’s election as some sort of watershed that will immediately usher in much weaker Italian bonds and a much weaker euro. However, the more the fundamentals of the country deteriorate – as seems likely – the more Italy’s asset prices and the euro will slide and, in the end, this could push Italian politics to the forefront of market attention, unlikely the current situation where it still lies somewhat in the background.