Markets Calm As The Italian Democratic Party Craters In The Polls

Italian Election Update

The general election in Italy is now about a month away as it will be held on March 4th. The chart below shows the latest trends in the polling. As you can see, the left leaning establishment People’s Democratic party has been cratering in the polls. This shows the high level of voter unrest even though the European economy is in a cyclical upswing. This is just like how President Trump won the U.S. presidency based on economic unrest in the Midwest despite solid overall economic conditions. The right wing 5 Star Movement has maintained its level of support consistently. Flat polling has allowed it to gain the lead. The Lega Nord has been falling modestly and the Forza Italia party has been gaining ground steadily. Even with this huge wave election coming, investors aren’t worried. This election, which could have been a risk to American markets, has barley even effected the Italian bond market even as the ECB has pulled back on bond purchases this year. Year to date, the Italian 10 year bond yield is almost flat as it’s up 0.64%.

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The chart below shows the Italian unemployment rate. As you can see, the seasonally adjusted rate fell to 10.8% in December 2017 which was the lowest jobless rate since August 2012. The cycle high of 13% in November 2014 was also the all-time high. Italian bond investors might be looking at the Italian economy and hoping it will follow in Greece’s footsteps. Greek unemployment fell from 27.9% in July 2013 to 20.7% in October 2017. The problem for Italy is that there are structural issues in the south as the migrants coming to Sicily aren’t being properly integrated into the economy. The discomfort in southern Italy is like the Midwestern discomfort in the 2016 U.S. election. That’s why we’re seeing the Democrats in Italy collapse in the polls. While I think the Italian economy is rebounding, I heed the election warning which shows all is not well. People re-elect the incumbent party if the economy is doing well for them.

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Even with the change in the polls, the chance of Italy leaving the E.U. in the next 12 months is still below 10%. That’s because the right wing still needs to form a coalition government after the election. Secondly, the right wing has moderated its stance as it has become more popular. This is a common trend; a politically extreme party gains more popularity which causes it to mellow its message. There is no pathway to Italy leaving the E.U. in the next year since the 5 Star Movement wouldn’t initially try to leave the E.U. even if it had 100% control of the government. The big worry is that in the next recession, when the economy is faltering, the right-wing parties are more likely to support Italy leaving the E.U. than the Democrats. Therefore, the chance of Italy leaving the E.U. is much higher in the next 5 years.

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The final Italian chart we’ll review is the cumulative changes in Italian bond buying in the past 7 years. As you can see, through the QE program, the ECB bought a lot of Italian government bonds in the past 2 years. This will change dramatically in the next 2 years. The Italian households might need to step up their buying to prevent yields from skyrocketing. The ECB bond buying went down by €30 billion per month in January. The change has worked out even with the stress of the elections in place. Just like how U.S. stocks have rallied and financial conditions have loosened without the Fed being extremely accommodative, the Italian bond market has been able to withstand a couple rounds of tapering. The biggest question is what happens at the first sign of trouble? Do the central bankers stop the bleeding immediately or let markets tank?

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Views On Tax Bill Change

The University of Michigan consumer confidence index for December appears to have fallen because of the unpopularity of the tax bill. I had expected it to become more popular since it’s estimated that about 80% of people will get a tax cut. This isn’t a partisan point. I’m merely saying the tax cut being less popular than previous tax increases is a factor which is unsustainable. That’s good new for the economy as people start to spend the influx in disposable income. This thesis has proven to be correct as the latest poll shows 44% approve of it and 44% disapprove of it. This is a massive improvement from the poll in December which showed 26% approve of it and 47% disapprove of it. In the same mindset, those saying the tax bill will cause an increase in taxes fell from 50% to 36% and those saying it will cut taxes has increased from 14% to 24%.

The mock Congressional poll went from showing Democrats having a 15% lead in December to only a 2% lead in January. This swing could mean the GOP does better in the midterm elections than I previously expected. That increases the odds that the GOP will maintain its control of the Senate and the House of Representatives. The stock market should prefer the GOP in power because the Democrats are more likely to raise the corporate tax rate.

Conclusion

Coincidentally, the unaffiliated Democrats in Italy and America lost ground in the latest polls. It’s bad news for the stock market that the Italian Democrats are losing steam as the election approaches because it increases the odds of Italy leaving the E.U. if economic strife returns. Italians are already restless as the young educated unemployed people in the south are leaving the country to find good paying jobs.

The Democrats losing ground in America is probably good news for stocks because investors love the tax cut. The S&P 500 is up 5.76% year to date. I’m sure most investors will want to keep the good times going. To be clear, the good times will end in the next couple years regardless of which party is in charge. The key is to separate fiscal effects caused by changes in party control from cyclical effects caused by changes in the debt cycle and global trade trends.