The result of the elections in Italy in March 2018 showed that voters are willing to try new political formulas to solve the structural problems which have plagued the Italian economy. After decades of slow growth, tight government budgets and dysfunctional politics, the current Italian government is ready to take on the EU and its strict budget rules.
The draft budget for 2019 was rejected by the European Commission and now the Italian government has to present an alternative plan. The negotiations between Italy and the EU will probably drag on in the coming months, but ultimately the Italian government will have to present a credible fiscal plan in order to attract investors back to its government bond market.
Where we come from: politics, politics
The Italian elections on March 4 resulted in a bit of stalemate as no party achieved a majority. Both Lega Nord, the center-right coalition led by Matteo Salvini and the Movimento 5 Stelle led by Luigi Di Maio increased their parliamentary foothold considerably. Despite the political differences, an agreement was reached between the two parties and Giuseppe Conte was appointed as Prime Minister.
Right after the elections, the difference in yields between Italian and German bonds remained quite stable. Stronger economic numbers across the eurozone and the ECB bond purchase program reinforced investor complacency. However, after Salvini and Di Maio reached an agreement, nervousness on bond markets increased as it became evident that the new coalition had a strong appetite for unwinding some of the structural reforms implemented in the past few years, as well as considerably increasing the government budget deficit.
The final details of the budget were announced on October 15, a few minutes before the EU deadline. According to this proposal, Italy aims for a budget deficit of 2.4% in 2019, declining to 2.1% in 2021 and 1.8% in 2021. The expected growth is set at 1.5% over the course of these three years, well above historical average. The European Commission rejected this budget and pointed to the necessity to reduce the excessive Italian government debt, currently around 130% of GDP.
Since the elections and until now, the bond market has been able to discriminate between countries. As an example, Spanish and Portuguese debt markets have remained quite stable, especially compared to what happened during the European sovereign crisis in 2010. At that time, doubts about the common currency and the viability of Europe as an integrated region pushed peripheral spreads to extreme levels. Today, the situation is different. The existence of risk-mitigating tools such as the European Stability Mechanism and potential market intervention by the ECB reduce potential spill-over effects. But these factors offer no help for the Italian bond market yet, with spreads widening to the highest levels in five years.
The existence of fundamental differences between countries makes it more difficult for the ECB to come up with a single common monetary policy. ECB members reiterate that their mandate does not allow directing its policies at an individual member of the eurozone. Thus, the ECB continued its path of withdrawing the extraordinary measures in place by gradually reducing the amount of bond purchases. We expect the ECB balance sheet will stop expanding as of January 2019, with the first rate hike probably in the final quarter of next year.
The reduced support of the ECB as a marginal buyer of sovereign debt, together with the need of Italy to finance its extra budget at an already high debt-to-GDP ratio puts the country in a very sensitive position, in which it needs strong support from both local and foreign investors. With the current budget proposal, economic growth needs to be exceptionally strong in order to reduce the overall debt levels, and any unexpected recession could cause the deficit to increase easily.
Aegon Asset Management view
We are constructive on Italy on a long-term basis. Across eurozone countries there is undeniable popular support for the European project. The progress made on increasing the eurozone financial stability mechanisms is a clear example of solidarity and cooperation. However, our current positioning reflects a cautious view, considering the large gap between what was promised to Italian voters and the European budget rules. The Italian government will have to substantially adjust its current budget plans in order to pass the EU review. This might require some more market pressure through spread widening on Italian bonds. Taking into account how the large stock of Italian sovereign debt increases vulnerability to market shocks, a credible fiscal plan is the best tool to reverse investor scepticism.