In many ways, Italy’s new coalition government reminds us of president Trump. Market reaction has been negative but we suspect it is overdone and we are keeping the faith with Italian and eurozone assets.
Having been concerned over recent years about the possibility of a 5-Star government, we are now confronted with the reality. The scary thing in the past was the idea that they would try to take Italy out of the European Union. They seem to have dropped that idea and are more focused on reforming the EU. If Italy stays in the EU, we suspect that markets will recover and we stick by the idea that Italy’s will prove to be among the best performing eurozone debt markets in 2018.
The coalition between Italy’s Five-Star Movement (5-Star) and The League published in mid-May an online version of their policy programme: the 58 pages covered a lot of ground and, though it did contain some specifics, was mainly aspirational and was not costed.
Looking at the entirety of the document, one could almost believe the coalition partners have taken a leaf out of president Trump’s book: reduce tax rates and the regulatory burden; increase spending (military, infrastructure, education & research); antagonise your neighbours and partners (EU); get friendly with Russia; target immigrants and drain the swamp.
From an economic and financial market perspective, the “good” proposals include:
- The reduction of the corporate tax rate to 15% or 20% (not clear which), from the current 24%.
- The elimination of corporate red tape and simplification of judicial processes (it is not easy to be an entrepreneur in Italy).
- The proposals to increase spending on infrastructure, the military and education/research and to establish a state investment bank could be good for an economy lacking dynamism.
- There are several proposals that could boost incomes at the lower end of the scale: introduction of a minimum wage; outlawing the use of unpaid internships and the establishment of a “citizenship income” of €780 per month (effectively unemployment benefit). Because the money is going to the low paid, with high marginal propensity to consume, this could boost aggregate demand.
- Anti-corruption measures on a broad basis and anti-graft measures against politicians.
Unfortunately, there are also areas that may be of concern to financial markets. The “bad” proposals can be summarised as:
- Several proposals calling for reform of the EU that will likely cause friction with other member countries (and speculation about Italy’s continued membership). The common thread is to make fiscal and monetary policy more suited to the weaker members of the EU. As such, there could be support from countries such as Greece, Portugal and Spain but opposition from Germany and other “Northern” nations.
- A big negative for the banks is the proposal to remove their ability to act against debtors without judicial authorisation. Also, it is possible that the new state investment bank could take business away from them.
- The rolling back of reforms to the pension system suggests an unwillingness to confront demographic reality. The proposal is that retirement can occur when age plus number of years of contribution reaches 100. The €780 per month “citizenship income” will also apply to pensioners.
Though costings are missing, the plan to reduce taxes and boost spending could result in higher budget deficits and eventually to higher debt (the coalition believes that stronger economic growth will reduce fiscal deficits and debt).
The IMF reckons Italy’s gross government debt/GDP ratio will be 130% in 2018 (118% if net debt is used). Net interest payments of Italy’s government absorb around 3.5% GDP. That is not as bad as in the past but is well above the interest burden faced by other big eurozone governments.
There are some “ugly” elements to the plan (depending on your point of view):
- Without giving much detail, there is the expected undercurrent of racism and anti-immigrant sentiment.
- As with president Trump, there is an almost jingoistic desire to put Italy and Italians first.
Though markets have focused on the negative, we believe the proposals include many market friendly policies (lower taxes, simplified tax system, streamlined judicial processes, more spending etc). After initial scepticism, US markets eventually bought into that sort of programme from president Trump.
The big problem will come if bond yields are much higher than we expect, with no extra growth, as this could put government finances on an unsustainable path. If they implement their plans, it is to be hoped they are right about the extra growth reducing debt.
All the above assumes this government endures, firms up its policy proposals and implements them. These are big assumptions for an Italian government: we suspect the internal contradictions within the coalition could be fatal; once they start to cost these programmes, it will become apparent that choices must be made and, finally, successful reform is not usually associated with Italian governments.
However, as was stated above, if Italy stays in the EU, we suspect that markets will recover and Italy’s will prove to be among the best performing eurozone debt markets in 2018.
Paul Jackson is head of Research, EMEA ETFs, Invesco
