An Italian game changer?

The apparent collapse of the populist coalition government in Rome could have far-ranging repercussions for the Eurozone.

Italian politics is in turmoil once again. The ruling populist coalition between the far-right Lega and the Five-Star movement appears to have collapsed. Giuseppe Conte, the country’s technocratic prime minister, has signaled that he stands ready to face a vote of no confidence in parliament.

For many investors, political instability in the south of the Eurozone may evoke a sense of déjà vu. Since the Eurozone crisis began to unfold almost 10 years ago, fits of political disarray have been a regular occurrence only for fiscal-policy making to remain fairly unadventurous, no matter who was nominally in charge.

It is possible that ties within Rome’s fractious coalition partners might be patched up, as previous rifts have been before. The cause of the latest conflict is a trans-Alpine high-speed rail link with France, which has already been in planning for decades. Lega, business groups and what is left of Italy’s political establishment is in favor. Five Star, which partly began as a green protest movement has long been campaigning against TAV, as the rail link is known. On Wednesday, August 7, Five Star tried to block the project in the Senate, but was outvoted by Lega with help from the opposition.

It might therefore appear odd that it is Lega now trying to pull the plug on the coalition. But tensions have been growing for months, especially after Five Star backed Ursula von der Leyen in her successful bid to become president of the European Commission. All of which is a reminder that while both Lega and Five Star may have been labelled populists by political scientists and various commentators, they have vastly different political priorities. Indeed, pretty much the only issue the two have consistently agreed on is their fierce opposition to the Eurozone’s stability and growth pact, which they blame for preventing the sort of fiscal easing both promised their respective voters.

This is also precisely why we think investors might be wrong to view the latest drama unfolding in Rome simply as a case of déjà vu. As yet, it is still far from clear if and when snap elections might happen. This is first because Italian polling has notoriously been unreliable, making it uncertain whether Lega‘s polling strength could actually translate into a centre-right majority. Lega’s leader Matteo Salvini might also fear further revelations on recent party-funding allegations known as "Moscowgate". The earliest a general election could be held would probably be in late October or early November, increasing the risks to the Lega of their electoral performance being completely different from recent polling and election results earlier in the year. To complicate matters, any electoral campaign around that time play out just as the Italian government of the day is supposed to submit a new budget to the European Union (EU). If it does not, Italy might be forced to raise value-added tax (VAT). So, no matter what he says in public, Mr. Salvini might not be all too unhappy privately if elections are delayed and an alternative government implements a budget containing unpopular spending cuts.

Second, Lega’s polling strength came largely at the expense of Five Star. So, while Lega may have incentives to engineer a snap election, the opposite remains true for Five Star, especially as many of its lawmakers appear to be rather enjoying the perks that come with holding high office.

Third, it is not up to the current coalition to decide on whether and when to hold yet another snap election. Under Italy's constitution, only the president has the power to dissolve parliament. President Sergio Mattarella is likely to do his very best to prevent such an outcome, perhaps by encouraging the centre-left Democratic Party (PD) to come to some sort of an agreement with Five Star. Such a combination is likely to face fierce opposition within both groups. Perhaps, though, another government heavy on technocrats such as Mr. Conte and finance minister Giovanni Tria could make it palatable for enough lawmakers to secure comfortable majorities in both houses of the Italian parliament.

In the short term, most investors probably wish that snap elections can be avoided. They should be careful in what they wish for. One thing that has become increasingly clear: being highly critical of austerity and trying to resist "reform suggestions" from Brussels may be Italian government policy for the foreseeable future, no matter which of the major groups is in power. At the same time, the rest of the European landscape is already changing, with the electoral victory of Spain‘s socialists and the looming departure of Angela Merkel in Germany. All this might well influence the composition of the new European Commission and could lead to more "flexible interpretations" of the EU deficit criteria concerning highly indebted countries such as Italy. Having supported Ms. Von der Leyen, a left-wing populist government in Rome might even find powerful allies not just in Madrid, Athens and Paris, but even in Brussels.

When it comes to European sovereign bonds, markets have lately been firmly following the script of the Eurozone turning Japanese, in the sense of interest rates remaining low as far as the eye can see. Inflation risks have largely been priced out, not just for the immediate future but we believe for decades to come. Of course, there are still ways to deal with negative returns, as we have recently shown (see Chart of the Week: How one might beat negative government-bond yields as of 8/2/19). Shifts in monetary policy on both sides of the Atlantic could well see the trend towards ever lower yields and ever more expensive bonds to continue for quite a bit longer. But when it comes to the Eurozone, it will certainly seem to us that history and the continent’s changing political economy suggest an obvious alternative to Europe turning Japanese. A risk worth keeping in mind is that in the medium to longer term, it could instead turn a little more like Italy was before the creation of the common currency two decades ago. That mean looser fiscal policies, and, eventually, higher inflation rates than many market participants have gotten used to.

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