Italian coalition heightens European instability

With a right-wing populist coalition in the making, could Italian politics threaten both domestic and European stability?

Italian flag
Source: Bloomberg

Italian politics has grabbed the headlines this week, as the prospect of a populist coalition between the Five-Star Movement (M5S) and League parties raises a whole host of uncomfortable issues for the EU. The far-right coalition has promised much, yet the delivery of those ideals will require significant changes within the EU, bringing heightened uncertainty for investors.

From a market perspective, the decline in Italian bonds is indicative of a substantial erosion in confidence over the direction of the economy. There is also the prospect of greater conflict with both the EU and European Central Bank (ECB), with talks of debt writedowns, and defiance on a host of issues being touted.

The dominant fear that has been dragging the euro lower has been centered on an Italian exit from the single currency. The potential for ‘Italexit’ strikes fear into the heart of many, yet this is unlikely to be an issue that needs too much consideration, despite previous comments. While there was a clear Eurosceptic theme running through their campaign promises, we have since seen M5S parliamentarian, Alfonso Bonafede, signal that an exit from the single currency is not an option. Instead, we are expecting to see a relatively combative approach from the coalition when dealing with the EU and ECB. Perhaps the biggest potential source of friction with the ECB came in the form of a request to write off 250 billion euros worth of debt. However, today’s key points that have surfaced from talks between both sides have made no reference to this, highlighting an initially diplomatic approach being taken.

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The issue of debt is going be crucial in this whole process, with many of the measures initially proposed by the two parties expected to drive debt higher. Some of the key policies widely anticipated under this coalition are a cancellation to the planned sales and excise tax hike, a rise to the minimum wage, abolition of the recently agreed pension reforms, increases in welfare spending, and a cancellation to the planned rise in the age of retirement. Many of these elements are negative for the public purse, with measures either reducing the tax obligations of workers, or raising the financial obligations to the worker.

The clear outcome from driving up future government expenditure and reducing future income is a marked increase in debt. Italy already has the second highest level of debt to gross domestic product (GDP) in the eurozone after Greece. This issue of debt sustainability is going to be absolutely crucial in determining market confidence in the coalition, given the willingness to row back on policies that were only recently implemented with a view to bring down debt and improve Italian fiscal stability. However, members of M5S have claimed that the deficit will not increase for a number of reasons.

Firstly, the coalition plan to request a writedown of some 250 billion euros worth of debt from the ECB. This would reduce interest repayments and clear many of the current liabilities faced by the government. Secondly, the coalition believe that by lowering taxes and raising the minimum wage, they will ramp up economic growth. This, of course, can be a somewhat risky presumption to make.

Part of the reason why markets are so hesitant of this coalition will be related to the notion that to truly satisfy their promises they will have to take on the EU and ECB on a host of topics. These could be budget policy, debt, immigration, trade policy, and their relationship with Russia. This coalition is likely to have an impact on both the economic standing and stability of Italy, alongside the running of the EU, given the concessions that this coalition are likely to approach. This combative approach highlights why the euro has been the biggest underperformer of the week.

While we have seen the most recent repetition of the coalition’s proposals writing off some of the more controversial elements, there is still a strong chance we will see some of them resurface over time.

On the market front, the Italy 40 index has been falling drastically throughout the week, losing over 3% (700 plus points) in the last three days. The deterioration in the euro does help act as an automatic stabilizer, for with a weak euro comes improved stock market valuations. Thus there is a good chance that the deterioration in Italian stocks will be relatively short-lived, if the euro continues its decline. This week has clearly provided a significant risk of another leg lower next week. But as long as the index does not fall below 21,270, a bullish theme remains in place.

However, continued fears would likely continue to play out in the fixed income market, where investors demand an increasingly higher reward for holding Italian debt. Therefore, should we see the coalition indicate a return to their hardline measures, it would be likely that Italian bond prices fall further, driving yields upward.   

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