Italy: Stress is here to stay

Italy Stress is here to stay

  • 88 days after the Italian parliamentary election, and an episode of exceptional financial market stress later, the Five Star Movement (M5S) and the Lega have sealed their governing alliance. Significant uncertainty remains however regarding the political and economic outlook. We defined four key political scenarios based on the fiscal measures implemented by the government and their relationship to the European institutions
  • Baseline scenario (50%) assumes that the government implements only a portion of announced fiscal stimulus and finds a conciliatory approach with Europe.  Italian 10-year spreads to the Bund will remain between 180bps and 250bps. GDP growth would more than halve by 2020 to 0.6% with debt-to-GDP embarking on an upward trend to 134% by 2020
  • Upside scenario (30%) foresees the implementation of limited fiscal measures while the government maintains a constructive approach towards Europe. Spreads would still be elevated with less volatility, GDP growth would moderate to 1% in 2019/2020 while public debt stabilizes at 132% of GDP
  • Downside scenario (15%) assumes a sharp rise in fiscal spending with the coalition embarking on a collision course with the EU. Spreads would rise by an additional +200bps compared to the baseline; Italy could slip in a shallow multi-year recession with debt rising above 140% by 2020.
  • Italexit (<5%) assumes that a political event or a market default, combined with a confrontational stance causes substantial financial stress (spreads up by +500bps to the baseline). Italy would undergo a very deep recession with debt-to-GDP rising towards 160% by 2020. Contagion would follow.
  • In its relation with Italy the European Union will have to strike a delicate balance between upholding its own rules while at the same working constructively with the new government with a view on making more tangible progress on EU reform

What’s next for Italy? Four scenarios for 2018-20

88 days after the Italian parliamentary election on March 4, and after one failed attempt to form a governing coalition that triggered an episode of exceptional financial market stress, the Five Star Movement (M5S) and the Lega parties sealed their governing alliance.

Nevertheless significant uncertainty remains regarding the political and economic outlook for Italy particularly given the M5S/Lega government‘s ultra-expansive fiscal policy which includes tax cuts and higher spending to the tune of EUR126bn (about 7% of GDP). There are significant doubts regarding the government‘s ability to implement the proposed fiscal plans given institutional curbs. In addition, further financial stress may as well as limit appetite for Italian government bonds.

There are four key scenarios depending on the new government’s policy choices. .

1. Baseline: Policy U-turn after Significant Fiscal Expansion combined with Moderately Confrontational EU Approach

Our base case considers significant fiscal expansion coupled with Eurosceptic rhetoric to trigger a notable increase in market tensions. Substantial financial stress will prevail fueled by the downgrade of Italy’s sovereign rating by one notch following the presentation of the government’s 2019 budget plans in October. This help explains the expected U-turn in fiscal profligacy (30% of the proposed measures in 2019; 10% additional in 2020), and in the confrontational posture with the EU.

Such assumptions lead to a fiscal multiplier boost of +0.4pp to GDP growth as soon as 2019 but the deterioration of the fiscal deficit from -2.3% of GDP to -3.5% is expected to keep sovereign bond spreads relatively elevated (above +200bp over the 10-year compared to the Bund). In addition, fickle confidence will be a drag on the private sector. Overall, we expect GDP growth to reach +0.8% in 2019 after +1.2% in 2018. Keeping a positive primary balance initially helps avoid a more significant deterioration in market sentiment towards Italy. We estimate the fiscal primary surplus to fall from +1.5% of GDP to +0.3% before turning negative in 2020 – for the first time since 2009. Italian public debt will rise to 134% by 2020 up from 132% of GDP in 2019. The fiscal deficit is expected to be greater than -4% of GDP in 2020.

The spillover to other peripheral countries is expected to remain contained. The ECB will stay on course by extending its QE program until end-2018 and increase interest rates for the first time in H2 2019.

For the ECB to do more, financial stress would have to be more tangible: (i) a broad flattening of yield curves endangering banking system liquidity access; (ii) a significant loss of confidence among Eurozone banks (Euribor-Eonia spread above 1%; and (iii) peripheral spreads durably above +400bp.

Overall, the ECB holds EUR345bn of Italian public debt (around 18% of total bonds outstanding). Starting in 2019 we expect the ECB to buy Italian bonds as part of the reinvestment of principal only following its QE exit. The average monthly amount of ECB purchases of Italian bonds will be EUR3bn compared to almost EUR4bn since the start of 2018 or around EUR10bn in 2017.