Italian coalition heightens European instability

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.