FEB Market Update 2018 Italy’s (Definitely Complicated) Election Giuseppe Ricotta, CFA, FRM, Senior Vice President, Portfolio Manager/Analyst Guillaume Samama, CFA, Vice President, Research Analyst Italy’s political future was thrown into doubt a little over a year ago after the then-Prime Minister Matteo Renzi resigned following the electorate’s rejection of the constitutional reforms he had championed (for details see our Lazard Market Update, Comments on the Italian Referendum Result). We believe the referendum was a missed opportunity for positive reforms and that the next general election, scheduled for 4 March this year, could be pivotal for the country’s direction. In this paper, we discuss the election, the new electoral system, the potential for a hung parliament populism and other risks, and potential election scenarios. We use scenario analysis, conducted by our Multi-Asset team, to gauge the possible market reactions and economic implications for investors. A Missed Opportunity From 2014 to 2016, under the leadership of the centre-left Democratic Party (PD) and Prime Minister Renzi, Italy’s budget deficit remained well below the European Union’s (EU) headline target of 3.0% of GDP, and the labour market and banking sector underwent a series of transformations. The constitutional reform, to which Renzi staked his political future, represented an opportunity to drive reform efforts forward. The proposed constitutional reforms of 2016 would likely have made it easier and faster to pass new laws, as it would have lessened the Senate’s law-making powers and introduced several new paths to enact laws. We regarded these reforms as potentially transformational and, in our view, they would have been a positive step for Italy, in contrast with the present situation in which the Lower House (or Chamber of Deputies) and the Senate—which together comprise Italy’s parliament—have equal voting powers. At present, all laws have to be approved by both chambers, which often results in a bill being passed back and forth between the two, making it difficult to approve key reforms and, in some cases, altogether preventing their adoption. The electorate rejected the referendum and, in October 2017, the government passed a new law governing how the members of the Lower House and the Senate (which continue to have equal powers) are elected. Under the new electoral system, it is possible for a party or coalition to win the popular vote and command a comfortable majority in the Lower House, while at the same time winding up with slim support, or perhaps even being in the minority, in the Senate. Although we think that the proposed constitutional reform was a missed opportunity, Italy’s next government has a crucial role to play in deciding the country’s direction. The New Electoral System Exhibit 1 Italy’s Main Political Parties Votes at the upcoming general election will be cast under the new electoral system for the first time. The Party Ideology Leader new system is a hybrid of two electoral systems—first- Free and Equal (LeU) Left Pietro Grasso past-the-post and proportional representation—and is Democratic Party (PD) Centre-Left Matteo Renzi intended to promote political stability. In recent years, Forza Italia (FI) Centre-Right Silvio Berlusconi no single party (Exhibit 1) or coalition has managed Northern League (LN) Right Matteo Salvini to win an outright majority in Italy, giving rise to the Brothers of Italy (FdI) Right Giorgia Meloni formation of grand coalitions after each election. 5 Star Movement (M5S) Anti-Establishment Luigi Di Maio Source: Chamber of Deputies of the Italian Parliament, Lazard LR29759 2 While it is set to be tested for the first time on 4 March 2018, Exhibit 2 the new system encourages parties to build pre-election alliances Support for the Ruling Democratic Party is Waning and also favours locally well-established parties. For this reason, (%) the anti-establishment Five Star Movement (M5S), with its 35 populist policies and Eurosceptic views, is expected to be at a disadvantage despite its lead in the polls. 30 M5S Although the M5S has recently softened its stance on forming 25 PD pre-election coalitions—having been vehemently against 20 it in the past—few parties have been willing to ally with it. FI Furthermore, despite its strong showing in national polls 15 LN (Exhibit 2), M5S does not generally have strong support at the 10 local level, as reflected by recent municipal election results. LeU 5 In the Sicilian regional election in November 2017—considered FdI 0 by some to be a barometer of Italy’s general election—centre- Jan 2017 May 2017 Sep 2017 Jan 2018 right parties made strong gains, trumping both the M5S and As at 8 February 2018 the centre-left PD. The election result was a blow to the ruling Source: Quorum, YouTrend centre-left government and some expect the same could happen in the upcoming general election, given that support for the PD has been waning in recent weeks as M5S and Silvio Berlusconi's Exhibit 3 centre-right Forza Italia (FI) have gained ground. Centre-Right Coalition Gains Ground (%) While polling trends could change in the weeks ahead of the Centre Right election, or indeed completely misjudge the outcome, as has 40 been the case with key elections in other countries in recent 35 years, current projections indicate that a centre-right coalition M5S 30 could far outstrip both a centre-left coalition led by the PD and Italy’s most popular party, M5S (Exhibit 3). 25 Centre Left 20 A Hung Parliament? 15 Despite the revamping of Italy’s electoral system to make the 10 country more governable, the three-way political gridlock Left indicated by polls suggests that no formation is likely to secure a 5 majority. If the polls are accurate, the election results will likely 0 Jan 2017 May 2017 Sep 2017 Jan 2018 be inconclusive (Exhibit 4). To achieve an absolute majority, a party or coalition must secure at least 316 seats of 630 total in As at 8 February 2018 Source: Quorum, YouTrend the Lower House. While some regard an inconclusive election as the least market- friendly result—it could potentially lead to months of political Exhibit 4 uncertainty—investors could also be encouraged if anti- Increased Likelihood of a Hung Parliament establishment parties are marginalised. Italy: Seat Projections The Fear of Populism Five Star Movement Centre-Right (M5S) FI-Lega-FDI (to be allocated) Voters’ rejection of Italy’s constitutional reform in December 170 2016 raised concerns that the populist M5S could gain power. Democratic 131 Party (PD) Since then, we would argue that this risk has receded, partly 170 Forza Italia 107 Berlusconi 266 aided by Italy’s electoral reform. We believe that the new voting Centre-Left 68 PD & Allies (to Lega system puts M5S at a disadvantage heading into the election 47 154 be allocated) 51 Salvini given its lack of traction at the local level and questions around LeU (Left) 27 27 16 Brothers its ability to team up with other parties. Furthermore, M5S has Total: 617 Seats* of Italy also softened its stance on holding a referendum on Italy’s euro (FDI) membership if it were to come to power, shifting its rhetoric as As at 18 January 2018 public support for the single currency has risen in Italy and in *Valle d’Aosta and Overseas constituencies are excluded The proportion of seats attained via first-past-the-post allocation and via proportional the euro zone (Exhibit 5). allocation will influence the overall number of seats achieved. Source: Ipsos Public Affairs Italy 3 Exhibit 5 Potential Election Scenarios The Euro Is Gaining Popularity We have identified five primary potential outcomes for the Do you think that having the euro is a good or bad thing for your election (Exhibit 6) and their implications (Exhibit 7). Our country? base case for Italy’s economic and investment landscape over A Good Thing the next six-to-twelve months is evenly balanced to the upside and downside, although we believe the probability of a left-tail (%) 70 negative outcome to be 10 percentage points higher than that of Euro Zone a right-tail positive outcome (Exhibit 8). The probabilities are 60 based on the Lazard Multi-Asset team’s analysis conducted as of end-January 2018. 50 Based on current polls, even a grand coalition between Renzi’s Italy PD and Berlusconi’s FI seems unlikely to be able to form a 40 2012 2013 2014 2015 2016 2017 majority, unless it is supported by some of the smaller parties from the right and the left. However, Renzi and Berlusconi could A Bad Thing reach an agreement to temporarily keep current Prime Minister (%) Paolo Gentiloni in office for a few more months, paving the way 50 for a technocratic government. A technocratic government could Euro Zone then be tasked with pushing ahead with much-needed structural 40 reforms, such as reforming the judicial system, modernising the public administration and further market liberalisation. 30 Italy The Need for Reform 20 2012 2013 2014 2015 2016 2017 Italy does face the possibility of repeat elections in a potential As at 31 October 2017 hung parliament scenario, which could significantly delay the Source: European Commission’s Eurobarometer Flash survey about the views and formation of a new government. This could result in successive attitudes related to the euro in the 19 euro area countries. elections being called or a less stable government eventually coming to power. While Germany has been without a formal The Threat of Populism Is Not the Only government for months following an inconclusive federal election in September of 2017, it has navigated the political Risk deadlock and emerged relatively unscathed.