Political events moved quickly in Italy over last weekend.
After weeks of coalition negotiations between the Lega party and the Five Star Movement (M5S), the biggest winners from the general election in March, President Sergio Mattarella vetoed their proposed finance minister, who was seen by many as a risky choice for his anti-euro views. The newly-appointed Prime Minister Giuseppe Conte resigned, and the President asked a former IMF official, Carlo Cottarelli, to form a caretaker government instead.
Far from welcoming the news, markets immediately discounted a likely re-run of the election after the summer. Italy’s two-year bond yield, which had been negative, shot through 2.5%—a level not seen for six years. The credit spread over German 10-year bonds followed suit, surging through 300 basis points intraday. The FTSE MIB Index of Italian equities is now down almost 8% since May 15. Investors were already on edge after weeks of volatility in emerging markets, a worsening political scandal in Spain and weaker fundamental data out of Europe this year. This sell-off appears to anticipate a stronger vote for Italy’s populists in a second election.
As we went live, there was some speculation that a new election might be called as early as July, as Cottarelli left his meeting with President Mattarella without a list of ministers for his caretaker government. In any case, a second election this year looks increasingly likely.
Uncertainty as the 2019 Budget Deadline Approaches
Back in March I warned that a coalition between M5S and Lega would be “the most market-negative outcome” from the election. While they have very different cultures and draw on very different voters, their common ground is a fiscal program of €125 billion worth of tax cuts and spending. Markets responded modestly, however, because both parties had softened their anti-euro rhetoric and would face a struggle to get their full program through parliament.
That consensus began to break down when the coalition-builders proposed the euroskeptic economist Paolo Savona as its finance minister. President Mattarella controversially cited his responsibility to prevent “uncertainty over our position in the euro” as his reason for rejecting Savona and appointing Carlo Cottarelli as prime minister.
Whoever forms the next government, their most urgent task will be to pass a 2019 budget before the end of the year. Without an agreed budget that respects the goals set in Italy’s Economic and Financial Document, a multi-year budget plan agreed with the European Union, a “safeguard clause” will trigger substantial automatic hikes in VAT and other indirect taxation rates.
Cottarelli has indicated that he will seek a vote of confidence from parliament to allow his government to draw up a budget. The controversial nature of his appointment, his reputation for austerity, and the parliamentary arithmetic delivered by the election in March presents a substantial risk of a vote of no confidence. That would necessitate a new parliamentary election. Cottarelli is a credible, market-friendly prime minister, but the market clearly doubts that he will be a stabilizing force for long.
Will Voters Think Twice, or Double Down?
If predicting the outcome of the March election was difficult, predicting the results of a second one is even tougher.
Now that the attempted appointment of Savona has brought the issue out into the open, M5S and Lega may have to clarify their stance on the euro. That is likely to mean a confirmation of the more conciliatory position they have adopted recently.
Nonetheless, they can still blame the collapse of their coalition on an out-of-touch Italian establishment that is committed to doing Brussels’ bidding. That could benefit them in the polls, given the constitutional controversy that President Mattarella has sparked in the name of defending Italy’s euro membership. Then again, it could push some of their marginal, protest voters back to the center, particularly if a bond and equity market sell off awakens fear for their financial wellbeing. Those are the dice the President has thrown.
So far, Lega appears to be performing best in opinion polls—up seven or eight points on their position in March. Again, a coalition with M5S based on stronger electoral arithmetic would likely be the worst outcome for markets, especially if it suggests a mandate to renegotiate with the EU. Polls still indicate this to be the likeliest result. Should Lega find a way to make a center-right coalition with Forza Italia and others, markets may consider that a less uncertain outcome. A coalition of the center right and the Democratic party would put market fears to rest, but it is doubtful that voters will make it possible.
Any government will face a very tight deadline for the contentious matter of passing the 2019 budget. Longer term, the probability that Italy will tackle its badly needed structural reforms fades as the populists progress, as does the probability of some kind of break with the EU and the loss of trust from investors.
Italy has benefitted from a return to growth and the measures implemented by its previous administration over the past year or so. Right now, however, to return to the title of the article I wrote in March, it is choosing a step into the unknown over continuity. Markets are re-pricing its risk accordingly.
Ugo Lancioni - Head of Global Currency - Neuberger Berman