Italy is back in the spotlight as Deputy Prime Minister Salvini turns up the rhetoric ahead of European Parliamentary elections. His controversial statements reopen old wounds from last fall and suggests similar market turmoil may be in store for the eurozone. Much will depend on the outcome of European Parliamentary elections this month.
In the eurozone, the focus recently has been more on politics than economics. Investors are watching Italy closely for signs of growing instability. Press reports suggest that Deputy Prime Minister Salvini of the League is preparing to bring down the coalition government it shares with the Five Star Movement.
Before, Salvini has warned that Italy may break EU fiscal rules to meet campaign promises to boost growth and employment. Earlier this month, Salvini suggested that taxes could be cut even if it leads to a breach of the -3% of GDP limit for budget deficits. Today, he pledged to “tear apart every single European rule butchering Italy.”
Salvini appears to be in campaigning mode ahead of European Parliamentary elections later this month. In terms of domestic Italian policy, these elections will have little direct impact and so for now, it is all talk and no action. However, the outcome will likely determine whether an early election will be held in Italy and that will have more serious implications for policy.
Observers suggest that if Salvini’s League does well in the European Parliamentary vote, then he will bring down the current government. As the junior partner in the coalition, Salvini do so to try and gain the upper hand over Five Star. Recent polls had shown rising popularity of the League over Five Star, but that support appears to have topped out in the mid-30s and has started to drop closer to 30%.
Tensions within the ruling coalition have been running high. Five Star Deputy Prime Minister Di Maio has publicly called on Salvini to tone down his remarks. The breaking point may have been Salvini’s efforts to control Italian shipping lanes in a bid to limit migrant rescue ships from docking at Italian ports. The Transportation Ministry should handle this matter and it is currently headed by Danilo Toninelli of Five Star.
Former Prime Minister Silvio Berlusconi has already called for new elections. If Salvini were to ditch Five Star, then he may need the support of Berlusconi’s Forza Italia to form a government. That is not seen as a natural fit and so more instability could be seen ahead of the next domestic battle this fall over the 2020 budget. Again, it may all come down to the results of the European Parliamentary elections.
A BRIEF HISTORY LESSON
The March 4 general election last year resulted in a hung parliament. Luigi Di Maio’s Five Star Movement won the most seats with 227 (out of 630 total), followed by Matteo Salvini’s League with 125 seats. The Democratic Party came in third with 112 seats and Forza Italia came in fourth with 104.
After months of negotiations, Five Star and League agreed last June 1 to rule in coalition. Salvini and Di Maio became co-Deputy Prime Ministers while independent Giuseppe Conte became Prime Minister. These two parties ran on populist and anti-immigrant platforms, respectively. As such, they have not found that much common ground with which to rule, except for being anti-establishment.
Last fall, Italy tried to bend the fiscal rules but was eventually forced to dial it back. Both houses passed motions in October backing the plan, which set a 2019 deficit target equal to -2.4% of GDP, -2.1% in 2020, and -1.8% in 2021. It assumed a reduction in the debt/GDP ratio in this period. However, the growth forecasts were criticized for being too optimistic.
The EU response to the 2019 draft budget was predictably negative. While the -2.4% of GDP deficit wouldn’t break the -3% limit, it meant that there would be no improvement in the debt/GDP ratio towards to the (arguably unobtainable) 60% limit. As it stands, Italy’s debt/GDP ratio remains stuck near 130%.
In November, the European Union (EU) identified Italy as being in “serious non-compliance” with the budget rules. This marked the start of excessive deficit procedures, which the EU said was warranted. Under pressure, Prime Minister Conte backtracked in December and said that the budget deficit would be targeted at -2.04% of GDP this year. Italy ended up avoiding an excessive deficit procedure and then things calmed down. Until now.
The economy is slowing. GDP growth is forecast by the IMF at 0.1% in 2019 and 0.9% in 2020 vs. 0.9% in 2018. The OECD is even more pessimist, forecasting -0.2% in 2019 and 0.5% in 2020. Bloomberg consensus sees 0.2% growth this year and 0.7% in 2020. GDP rose only 0.1% y/y in Q1 vs. flat y/y in Q4 and so we see downside risks to even the most pessimistic forecasts.
Italy and Germany have become the laggards in the eurozone. Even though Q1 eurozone GDP growth appears to have stabilized at 1.2%, the overall outlook remains soft. Eurozone GDP growth is forecast by the IMF at 1.3% in 2019 and 1.5% in 2020 vs. 1.9% in 2018. The OECD is again even more pessimist, forecasting 1.0% in 2019 and 1.2% in 2020.
In light of downside growth risks and low inflation in the eurozone, we expect the ECB to add more stimulus this year. This includes (but is not limited to) the TLTRO planned for this fall. Next ECB meeting is June 6 and more details about the TLTRO may be forthcoming then.
Mario Draghi’s term as ECB president ends this October and he will be a tough act to follow. The next ECB head will most likely hail from one of the northern eurozone countries. Erkki Liikanen of Finland is seen as a frontrunner, as are Francois Villeroy de Galhau and Benoit Coeure of France. Jens Weidmann of Germany has also been mentioned as a possibility.
The fiscal outlook has worsened. The budget deficit was -2.1% of GDP in 2018, and the European Commission sees it widening to -2.5% this year and -3.5% next year. The EC wrote recently that Italy will run a “sizable” structural deficit “suggesting that further fiscal adjustment is needed.” Slower than expected growth is the major culprit, but Salvini is adding fuel to the fire by pledging looser fiscal policy rather than tighter.
The external accounts remain solid. The current account surplus it was 2.5% of GDP in 2018, and the IMF expects the surplus to widen 2.9% in 2019 before narrowing to 2.6% in 2020. Italy’s Net International Investment Position (NIIP) is surprisingly low at -4% of GDP, down from nearly -26% in 2009. Whilst Italy’s external vulnerabilities remain low, a loss of confidence could result in capital flows out of Italy and into safer core eurozone countries.
The euro is in the middle of the major pack, -2.5% YTD vs. the dollar. While further stimulus seems likely this year, the ECB may be pushing on a string. With limited recourse, policymakers may simply choose to rely on a weaker euro to boost exports and growth. For now, the divergence story still favors the dollar and so we see the euro still getting squeezed by a broad-based dollar rally.
We see a test of the April low near $1.1110 in the coming days, followed by a break below the psychological $1.10 level. If we get that far, look for a test of the May 2017 low near $1.0840. After that, there is a gap between $1.0780-1.0820 from April 2017 that needs to be filled.
Italian equities are outperforming. So far this year, MSCI Italy is up 15.5% YTD and compares to 14.4% YTD for MSCI DM and 14.4% for MSCI Eurozone. Our DM Equity Allocation Model has Italy at VERY UNDERWEIGHT and so we expect Italian equities to underperform more in the coming weeks.
Italian bonds are underperforming. The yield on 10-year local currency government bonds is -6 bp YTD and is ahead of only the worst DM performer Singapore (+10 bp) and tied with Japan (-6 bp). The 2-year has done even worse at +20 bp. With the budget outlook likely to worsen as political tensions rise, we think Italian bonds will continue to underperform.
Our own sovereign ratings model shows Italy’s implied rating dropped a notch to BBB-/Baa3/BBB- this quarter, reversing last quarter’s rise. We see rising downgrade risks to the BBB rating from both S&P and Fitch, while Moody’s Baa3 rating looks to be on target.