Following recent elections, could Italy give the Euro the boot?

Thu 24 May 2018

Last year Europe was the darling of equity investors, as strong growth and improving sentiment throughout the Eurozone meant that it was only behind Emerging Markets in Sterling terms, which had a stellar year in spite of concerns about Trump, over the course of 2017. However, like Emerging Markets, Europe has had a relatively poor start to 2018, with an issue that everyone knew was coming – Italian elections – in the headlines in recent weeks.

A general election was held on 4 March to fill positions in the Chamber of Deputies (630 seats) and the Senate (320 seats), both of which are in essence equally powerful, with the approval of both needed to form a government.

And the winners? Well perhaps predictably, no one. However a block of parties that form the centre-right, led by The League, and the Five Star Movement on the left, appear to be about to form a populist coalition. It has taken the best part of three months to come up with a coalition deal after the election, with differences only bridged after the president threatened to form a “neutral” government led by technocrats in order to break the impasse. The parties have many differences, however share anti-EU sentiments.

Since neither side has absolute control, and are disinclined to see the other choose the prime minister, they appear to have settled on Giuseppe Conte, a little-known law professor for the role and the “the defence lawyer of the Italian people”.

Between them the parties have come up with some often wild proposals, with the following most concerning markets:

• A request for forgiveness of part of the national debt held by the ECB
• A proposal to exclude bonds held by the ECB from the calculation of the Debt/GDP thresholds set by the European Union
• A plan to create a development bank
• Implementation of a two-tier personal and corporate tax, an increase to unemployment benefits and a review of the current national pension scheme

CDS spreads are rapidly rising across Europe. The concerns are twofold – first these proposals require an increase in fiscal spending that the country can ill-afford given its Debt to GDP ratio is 132% (including bonds held by the ECB!), compared to an average of 87% for the Euro Area. The first two proposals around national debt fly in the face of EU rules and could see a confrontation with Germany, the largest economy in the EU. Greece tried a similar trick in 2015 which failed, and although Italy is a far larger, and more important economy, the precedent would see other countries such as Portugal and Spain demand the same treatment. Allowing any such move would be political suicide for a German Chancellor given the fiscally conservative nature of the country already unhappy about the amount tax payers have had to bail in other, less thrifty countries.

The second worry is that in the longer term, if the new government’s demands not being met / they are prevented by EU rule from carrying out their reforms, the coalition could threaten to withdraw Italy from the EU. Again this is the same threat that Greece made, but eventually backed away from as it would force the country to default on its debt and make funding future public spending almost impossible. Italy hasn’t been supported in the same way as Greece, but leaving the EU would mean its debt being sold by the ECB and would significantly increase its cost of borrowing, in all likelihood unsustainably so. There could be a domino effect as investors lose confidence in the value not just of Italy’s debt but other countries in the EU. It would likely mean the end of the EU project.

However the most likely outcome is that a lot of noise will be made, and some populist measures will be taken so that the government can save face, likely adding slightly to Italy’s debt burden. They are unlikely to be able to force Germany to accept these demands, but are unlikely to take an option that would be almost certain to lower living standards for their citizens. That said when Greece tried to play hard ball, although it caused ripples in financial markets, there was little threat to overall market stability or the EU in general as the economy is small on a global scale. In contrast any market fears about Italy could cause much bigger spikes in yields / CDS spreads for other European countries, the threat of which means Germany may not be able to ignore the country’s demands in the way it did Greece.

We expect to see volatility in the short term in both equity and bond markets as participants react to policy announcements, however the central case is that not an awful lot changes, aside from some relatively small policy changes that the Italian government can claim as a ‘win’. However we will be keeping close tabs on developments, and any signs of Italy withdrawing from the EU, such as expectations of a referendum on the issue, would see a revaluation of this position.