Emmanuel Macron's decisive victory in the French presidential election may calm markets for the time being, but investors will quickly turn their attention to Italy, where a populist anti-euro party leads in the polls and voters' EU sentiment is much poorer than in France.
The spread between French and German 10-year government bond yields — which had become a proxy for the risk of the centrist, pro-EU Macron's anti-euro rival Marine Le Pen winning the presidency — was around 45 basis points on the morning of May 8, having been as wide as 80 basis points in mid-February, reflecting investors' relief at the market-friendly result.
And there was more positive news for bond markets over the weekend, with German Chancellor Angela Merkel's center-right CDU party impressively winning an election in the northern state of Schleswig-Holstein on May 7. Taken together with the defeat of nationalist Geert Wilders in the Netherlands' general election in March, pro-Europeans might be beginning to hope that the tide has turned against populism in the bloc.
But investors will not be able to rest on these benign results for long, with an arguably bigger risk to the future of the eurozone looming in the form of extremely unpredictable Italian elections.
"The one we are still quite concerned about is Italy," said Azad Zangana, senior European economist at Schroders, in a conference call on May 8.
"The sick man of Europe, highly indebted, [with a] lack of growth, is now due to have an election by May of next year but it could happen sooner. The Five Star Movement is currently in the lead and that is a concern."
The anti-establishment and anti-euro Five Star Movement, led by comedian Beppe Grillo, has been ahead of Matteo Renzi's ruling Democrats in recent polls, on nearly 30%, while the equally anti-euro Northern League has recently polled around 13%.
In a blog post on the morning of May 8, Grillo branded Macron's incoming government as "dummies" who were "slaves to an impossible currency."
There are two major reasons investors should be more worried about Grillo than they were about Le Pen.
The first is Italy's economy, which is the eurozone's third largest and carries a total public debt amounting to more than 130% of GDP, compared to 96% in France.
Fitch Ratings cut Italy's sovereign debt rating to just two notches above junk in April, citing its debt pile, stagnant economy and struggling banking sector as the key risks.
The second is anti-EU sentiment among the electorate.
While Le Pen's threat to withdraw France from the single currency was a significant risk and taken seriously by the markets, polls in the run-up to the May 7 election consistently showed more than 60% of respondents in France had a positive view of the EU, making parliamentary support for such a move unlikely. In Italy, though, EU approval ratings are frequently in the low-30-percent area.
Five Star has seized on the deep unpopularity of austerity measures in Italy, particularly in poorer southern regions, and fueled the perception that such policies are coordinated by Germany and Brussels.
The mainstream parties have not been able to ignore that ill feeling. Matteo Renzi, who regained the leadership of his Democratic party in a vote April 30 after being forced to step down as prime minister in December 2016, rarely misses a chance to attack the EU's austerity agenda, and wants to increase public spending — "we aren't against the EU; we want a different one," he said after the ballot.
These risks will keep the positive impact of Macron's victory on eurozone assets limited, according to ABN AMRO fixed-income strategist Kim Liu, who sees Italian 10-year government bond spreads widening to 240 basis points by the end of 2017, up from 178 basis points now and nearly 100 basis points wider than his projection for Spain.
"The biggest political test for the eurozone is yet to come, which is the Italian elections, against the background of the country's poor fundamentals," he said in a note on May 8.
"In the second half of the year, we expect country spreads to widen, especially in the case of peripheral markets."
Sooner or later
Italian press reports have recently speculated that Renzi will push for elections as early as October, which would bring the anticipated volatility closer.
The "only bright spot," according to Commerzbank chief economist Jörg Krämer, is that Italy's constitutional court struck down a provision in the electoral law that would have awarded bonus seats — and thus an absolute majority in the lower house of parliament — to the strongest party in the second round, even if it failed to capture 40% of the vote.
The change to the election rules should prevent any single party, including the Five Star Movement, from gaining an absolute majority in parliament.
"While that is welcome as far as Italy's EU membership is concerned," said Krämer. "Italy will continue to be plagued by weak coalition governments [and] is thus no closer to solving its deep-seated economic problems.
"The EU can't keep feeling its way from one election to the next. At some point an election might go the wrong way — and if that happens in a large country, the survival of the monetary union would be in jeopardy."