A populist shift in Italy but not a systemic risk - J.P. Morgan Asset Management
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A populist shift in Italy but not a systemic risk

Contributors Maria Paola Toschi, Global Markets Insights Strategy Team

In brief

With a Prime Minister appointed, Italy is now forming a government around a coalition of two parties - Movement Five Star (M5S) and League (formerly Northern League). The populist roots of these political parties is generating volatility in Italian markets but we do not expect this to spread to concerns about broader European assets.

A generous spending programme

Both parties approached the election with a range of populist policies. Some of the more radical proposals that were linked to these parties in the past – such as a referendum on the euro – were dropped during the campaign as the economic recovery that is now underway in Italy reduced the desire of voters to dramatically alter the status quo.

The main elements of the government’s programme now include:

  • Tax reform – based on two tax rates of 15% for incomes below EUR 80,000 and 20% for salaries above;
  • A “citizen’s income” (or minimum income) for Italy’s poorest households; and
  • A lower retirement age that effectively reverses the retirement reform put in place by former Prime Minister Mario Monti.

Other themes include a tougher stance on immigration, and a reconsideration of certain proposed infrastructure projects such as a high-speed railway connection with France.

To reach an agreement the two coalition partners had to accept a third-party individual – Giuseppe Conte - to serve as prime minister. Conte’s academic background may suggest a more moderate, pragmatic approach to both fiscal and European policy. However, it is unclear at this stage how much influence this new prime minister will have in the decisions of the government.

Implications for Italy

In the near-term it is possible that these policies serve to boost Italian consumer confidence and spending. We have learned from both the Brexit referendum and the election of President Trump that economies can outperform the expectations established by economists immediately after a populist election result. But it is concerning that there is very little in the programme that addresses Italy’s structural problem of low productivity. The reversal of the pension reform is likely to exacerbate the challenges posed by the combination of low productivity and an ageing population.

Implications for Europe

Both the parties that form this coalition have toned down their anti-euro rhetoric. Ideas such as a referendum on euro membership, or cancelling the Italian debt held at the European Central Bank (ECB), have been dropped.

Nevertheless this government and its programme are likely to create some concern in Brussels. Funding for such a generous government spending programme has not been identified. Given government debt is around 130% of GDP, abandoning fiscal restraint while simultaneously reversing structural reforms is unlikely to please the European Commission or more fiscally-hawkish northern EU states. And the League remains very critical of the rules and regulations imposed by EU membership. More confrontation therefore still seems likely.

Implications for markets

Having remained surprisingly calm in the immediate aftermath of the election, markets have now reacted negatively to this government. Fitch – the rating agency - have already warned that the new government poses a risk to Italy’s current BBB sovereign rating. The 10-year Italian government bond yield has risen and is now 190 basis points higher than the equivalent German Bund yield, compared to 140 basis points just after the election result (Exhibit 1).

It is possible that the ECB’s government bond programme is muting the market reaction. The ECB at this stage has only committed to continuing its bond purchases through to the end of September. We have for some time been expecting an extension to the programme because of ongoing weakness in inflation. While it would never be openly acknowledged, the potential for sovereign stresses may provide another reason for an extension, although the ECB is running into constraints on the amount of bonds it can buy given the fact that German Bunds are relatively scarce.

Another factor that may serve to limit volatility in the Italian bond market is the relatively low levels of public debt owned by non-residents. Just 36% of Italy’s public debt is owned by foreigners, which is significantly lower than elsewhere in Europe, with foreigners owning 56% of German debt, 61% of French debt and 50% of Spanish debt. This may mean that volatility in Italian bond yields is somewhat tempered by stable domestic investment.

The Italian equity market has been one of the top performers in Europe year to date (Exhibit 2), largely due to financial stocks after progress on the resolution of non-performing loans. However, the FTSE MIB is now down 7% since the peak of 7 May. Within the overall index, the banking sector has been particularly badly hit, which may reflect the market’s concern that the new government is not committed to banking sector reform.

In the coming weeks we will find out more about whether this coalition can work together sustainably, its attitude towards fiscal restraint, and its approach towards its European partners. We have already learned that populist parties often have a bark that is fiercer than their bite. Our best guess is that while concerns over the new Italian government may add to the volatility of Italian assets, it won’t serve to derail broader European markets.

EXHIBIT 1: ITALIAN-GERMAN BOND YIELD SPREAD HAS RISEN ON RECENT DEVELOPMENTS
%, Italy minus Germany 10-year government bond yield


Source: Thomson Reuters Datastream, J.P. Morgan Asset Management. Data as of 23 May 2018.

EXHIBIT 2: ITALIAN EQUITIES HAVE RETRACED SOME OF THEIR GAINS
Index level, rebased to 100 at the start of 2017

Source: FTSE, MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. EMU is the European and Economic Monetary Union. Data as of 23 May 2018.

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