Why Markets are More Cautious About the Next Potential Political Pitfall



Donald Trump’s victory in the US presidential election means that markets have been caught off guard by unpredicted outcomes in two-way political races twice already this year. As we enter the final weeks of campaigning ahead of the Italian constitutional referendum, David Zahn, head of European fixed income, Franklin Templeton Fixed Income Group, explains that markets appear to be taking a more cautious approach to the next wave of potential political pitfalls, including next year’s general elections in Austria, the Netherlands, France and Germany.

Donald Trump’s surprise victory in the US presidential election may serve as a warning sign to Europe that populism can happen on a large scale. In Europe, generally speaking, populism has so far been confined to smaller countries. But there are already signs of increasing populism country by country across Europe, and that’s something we think European politicians are going to have to deal with. While we’re not expecting these populist movements to sweep to power imminently in upcoming elections, we think the polls suggest a malaise among many citizens, and that means the so-called European political elite need to listen to voters.

If Europe’s politicians don’t react by implementing change, we can foresee populist governments taking the reins in the not-too-distant future. The first effect of this might be seen in the Italian referendum scheduled for December 4, which seeks to reform the country’s balance of power within the government. Although the Italian constitutional referendum may seem parochial compared with the US election or the Brexit vote, it has the potential to bring further uncertainty to a European Union (EU) which is already struggling to digest the implications of Trump’s victory.

In many ways, it seems many Italian voters see this poll not as a referendum on constitutional reform, but on Prime Minister Matteo Renzi himself. Much depends on the outcome: A “yes” vote should reinforce Renzi’s mandate and allow him to push forward with his reforms. We’d expect Italian bonds to likely react positively in that outcome.

By voting “no,” voters may seek to express their dissatisfaction with Renzi and his policies. The implications of a “no” vote would, in our opinion, depend on the size of Renzi’s defeat. We’d expect him to be able to ride out a narrow loss, aiming to stay in power until 2018 when the normal election cycle concludes. But if Renzi were to lose by a substantial margin, meaning voters would have expressed their dissatisfaction toward the vote, and ultimately his leadership, we think he’d likely step down. In such a situation, the question would be whether a technocrat government could step in and take the reins until 2018. An alternative would be a snap general election, in which case it’s possible the populist Five Star Movement, the country’s largest opposition group, could make some significant gains. It’s not beyond the realms of possibility that Five Star might have enough support to form a government. In our eyes, that would likely be negative for bonds.