In recent months, financial markets have come to terms with the new political reality in Italy.
The populist parties M5S and the League agreed to form a government and proposed a cabinet to President Mattarella, with Giuseppe Conte as prime minister. Mattarella, however, intervened at the last minute, choosing to take a stand over the proposed naming of a eurosceptic finance minister.
The resulting turmoil led to a sharp sell-off in Italian assets and a significant widening in Italian government bond (BTP) spreads over core bonds. The spread of 10-year Italian yields over those of their German counterparts more than doubled from this year’s low of 113bp in late April to 290bp in late May, before settling at around 240bp at the end of the second quarter.
There are still a number of challenges and risks ahead, which have the potential to weigh further on Italian bonds. The new government’s aggressive agenda on fiscal loosening, which clashes with EU fiscal rules, and its strong stand on immigration mean that confrontations with the European Commission are still highly likely in the near term. Within the coalition, the two political parties have different constituencies and requirements from the budget, raising doubts about how long the current government will remain in power.
At the same time, the economy is slowing, and with a new government which is unlikely to pursue structural reforms to quickly rectify Italy’s long-term problems of low potential growth and high public debt, a deteriorating public finance outlook suggests an increasing chance of sovereign credit downgrades.
At the moment, Italian debt is rated two notches above non-investment grade and a one-notch downgrade could initiate a vicious circle between sovereign risk and financial sector stability, leading to yet higher risk premia to be priced into Italian yields.
Compared with the 2010-2012 European sovereign debt crisis, there are significant differences today. Italy has moved from a current account deficit to a surplus, suggesting it has excess savings rather than excess borrowing needs. On top of that, the Tesoro has been taking advantage of low interest rates and extended the maturities of its bond offerings. Indeed, the average maturity of Italian public debt has increased to close to seven years.
ECB purchases mean the public debt is mostly held by the Eurosystem and local investors, making the Italian bond market less susceptible to international selling pressure. GDP has grown steadily, albeit slowly, since 2014, and the deficit is smaller , making its near-term financing needs much more manageable.
However, the political backdrop is now far more challenging. While the rise in anti-establishment, anti-immigration, populist sentiment is not limited to Italy, one can argue that Italy has squandered political goodwill by not taking advantage of the time and favourable financial conditions provided by ECB quantitative easing (QE) to reform its economy, which makes it difficult for other eurozone countries which have pushed through painful reforms to provide a financial lifeline to Italy down the road should one become necessary.
We believe there are a number of near-term risks that will likely prove pivotal for financial markets and the Italian economy.
First, investors will be looking for more information and clarification about the government’s economic and fiscal policies. So far, Economy and Finances Minister Giovanni Tria has sent reassuring messages to the market that (i) the government will not be looking to leave the euro; (ii) the 2019 budget will remain consistent with the goals of debt and deficit reduction; and (iii) the state should repay its debts to businesses “on time and in cash” (i.e. distancing itself from the idea of parallel currency/mini-BOTs).
However, it remains unclear whether these commitments to fiscal discipline are simply soothing yet empty rhetoric to buy time in response to market pressure. We will see in the 2019 budget (due by September/early October) whether the government will indeed soften its radical approach and back its fiscal loosening agenda with strong and credible offsetting funding measures.
Second, it remains unclear how long this coalition government can remain in place, and as opinion polls for two political parties evolve, a snap election is still likely, in our view. Based on recent polling, M5S’s popularity has peaked, while support for League is rising. Matteo Salvini (interior minister and leader of League) seems to be benefiting from the implementation of a tougher anti-immigration stance. As League steadily overtakes the M5S in the polls, Salvini may reconsider running as a prime minister candidate in a centre-right coalition with Forza Italia.
A worse alternative scenario could be that M5S and League insist on their confrontational stances on public finance and immigration and jointly decide to return to the polls as a coalition again in an attempt to strengthen their political capital and increase their bargaining power with European authorities. In that case, the new elections would be perceived by investors as a proxy EU referendum and will likely send BTP-Bund spreads beyond 300bp.
Our baseline expectation is that the relationship between the government and Europe is likely to become more confrontational in coming months, but there should still be room for compromise. The government is unlikely to fully implement the economic and fiscal programmes it laid out in May. Fiscal loosening will likely be phased in gradually and backed by more explicit funding measures.
Sensing that Italians are tired of austerity and the lack of economic progress, European authorities may be willing to offer flexibility around Italy’s commitment to reduce the budget deficit to 0.8% in 2019.
Ultimately, the government is unlikely to seek an EU exit given the severe financial and economic consequences, as well as the fact that most Italians remain in favour of the euro. According to a survey released by Il Corriere della Sera in mid-June, despite the generalised weakening confidence in the EU, a majority of Italians would vote to remain in a referendum on EU (55%) or euro (49%).
Exhibit 1: Italy opinion polls
Note: full bar denotes results from March general election. Dashed bars denote the average of most recent opinion poll. Source: Macrobond, BNP Paribas, as of 31/05/2018
This article is an extract from the Inflation Linked Bond quarterly outlook for the third quarter of 2018