Populism makes a comeback in Italy

Political risk back on the agenda

Italy’s President Mattarella has just approved Giuseppe Conte as Prime Minister of the anti-establishment Five Star Movement and the far-right League. They have agreed on an unrealistic programme. Spreads are up, confirming the increased political risk.

Context

After the elections…

Two political parties stood out during last general election early March in Italy: the Five Star Movement (M5S) and the National Northern League (LN). They now have agreed on a coalition and a political programme to be headed by Giuseppe Conte as Prime Minister. The coalition’s programme looks unrealistic and would significantly increase Italy’s budget deficit. The main points:

• under certain conditions, a minimum income of 780 euros per month for workers who lose their jobs;
• a reform of the tax system, including, notably, a cut in marginal tax rates to 15% or 20% (for incomes above 80 000 euros);
• a reform of the pension system, unwinding part of the previous changes.

All three measures would put a serious dent in the government’s budget balance and the list is not exhaustive. Overall, the proposed measures are estimated to cost, each year, more than €100bn (i.e. 6% of the current GDP). The recent political developments have weighed on Italian bonds and equities.

Stable debt/GDP ratio, but…

In recent years, the Italian debt-to-GDP ratio has stabilized. In our baseline scenario, we forecast that the debt-to-GDP ratio would decline slightly, but slower than forecast by the IMF and the European Commission. We were expecting less growth, less fiscal tightening and a higher debt cost than both institutions.

Even assuming only a partial implementation of the proposed fiscal plan, Italian debt will again be on a clear rising trend.

While, recently, the European Commission has been rather lenient towards member countries not fully in line with their budget commitments, this could change for a country moving significantly out of line. Another risk comes from credit rating agencies. Moody’s has already put Italy on its negative watch list (Italy is only 2 notches above speculative grade).

Our strategy

Candriam’s views on Italian assets were and remain cautious. As this cautiousness has been implemented in all our strategies, we are rather comfortable with our current positioning.

Candriam has had a negative assessment of Italy’s long-term prospects due to:

• the weak economic growth dynamics;
• the vulnerable public debt sustainability.

We now anticipate more volatility on the Italian market, and believe Italy’s investment grade status to be in jeopardy if many of the announced measures were to be introduced.

Visibility is nevertheless still limited, as the agreed agenda still has to be executed. Relations with the European Union will also deserve attention, as the coalition’s parties adopted anti-Euro Zone rhetoric during their election campaigns. The next European Council on 28 and 29 June 2018 will bring more clarity.

Conclusion

Spreads have already started to increase and we believe the current high risk premium is likely to remain. In this context, we will keep a defensive stance on Italian bonds.

Italian equities have just recently started to underperform the Eurostoxx 50, after a strong start to the year, taking into account the same risk premium. We are now cautious on Italian equities as they are highly exposed to the banking sector, which owns much of the domestic debt.