Euro Uptrend Remains Intact While Italian Growth is Seen Lifted by Looser Purse Strings

© Grecaud Paul, Adobe Stock

For now the Euro's uptrend remains intact but a coming together of the Five Star and League anti-establishment parties, in a coalition government, would be likely to upset markets.

The Euro’s uptrend will remain intact for the time being despite uncertainty thrown up by Sunday’s election in Italy, according to a strategist, while Italian economic growth is predicted to pick up in the years ahead as the next government backpedals on years of post-crisis austerity and loosens the national purse strings.

However, higher fiscal spending and the threat of a destabilising breakdown in the relationship with Brussels is seen pushing Italian borrowing costs steadily higher in the medium term, while risks to the Euro still lurk in the long grass of the coming coalition negotiations.

“When a government is formed, we expect it to pass a small fiscal stimulus. After all, all of the major parties favour cutting taxes, albeit to different degrees,” say Jack Allen, a European economist at Capital Economics.

“We have pencilled in a fiscal boost worth about 0.5% of GDP in 2019 and 2020. This should help to keep the economy growing around its current pace of 1.5%, but would also cause the public debt-to-GDP ratio to rise.”

Italy has been a constant target for fiscals hawks in Brussels during recent years given its large debt burden, wide budget deficit and fragile banking system.

The Maastricht Treaty signed in the 1990s imposed a maximum limit of 3% on European Union budget deficits and a cap of 60% on debt as a portion of GDP. Italy complied with the 3% limit in 2015, 2016 and 2017 but its debt of 132% of GDP remains more than twice the cap.

Post-crisis updates to the Stability and Growth Pact give the European Commission powers to mandate further austerity from Italy and other countries, in the name of preventative measures, until such time as they comply with both the budget limit and debt cap.

“Given M5S’s previous anti-euro stance, perhaps the worst outcome would be them teaming up with the League. But whatever the outcome, we think that political uncertainty and the likelihood of looser fiscal policy will push bond yields up,” says Allen. “We have pencilled in the 10-year government bond yield rising to 2.75% by the end of the year.”

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Anti-establishment Parties Hold Balance of Power

Italy’s 2018 election saw established political forces routed by insurgents offering a menu of change, featuring an end to austerity and tougher migration controls. However, no party or coalition has 40% support needed to govern alone, much less an absolute majority of 50% or more.

“There is likely to be a lengthy period of negotiations between the major parties, which could last months. At this stage, it is very difficult to predict the outcome of these negotiations. And they might eventually fail, leading to a second election,” Allen warns.

“We doubt that on its own, the resulting political uncertainty would have much of an impact on the economy. After all, political instability is pretty much par for the course in Italy.”

The ruling Democratic Party (PD) saw its support slump from 40.8% in the 2014 European election to beneath 19% on Sunday. A fall of more than half.

Italy’s anti-establishment Five Star Movement (M5S) continued its insurgency when it emerged as the largest single political force, garnering more than 32% of the vote, up from the 21.2% share seen in 2014.

Five Star are the most opposed to European Union led austerity and have pledged to renegotiate Brussels’ fiscal rules or to hold a referendum on Italy’s continued use of the Euro currency. It has also, however, pledged not to enter into coalition government with any other party.

The Centro Destra coalition, featuring former PM Silvio Berlusconi’s Forza Italia, Lega, Fratelli D'Italia and Noi Con L’Italia took the largest share of the vote when combined together as a bloc, garnering 37%.

However, the rub here for markets is that it was the anti-Euro and anti-migration Lega party that emerged as leader of the coalition, with around 17.5% of the vote share, rather than Berlusconi’s more moderate Forza Italia.

“The centre-right did a little worse than expected, largely because Silvio Berlusconi’s Forza Italia (FI) underperformed. And because of that, a coalition between FI and the Democratic Party (PD), which before the election seemed like a possibility, is also less likely now,” says Allen.

 

Eurozone Integration Hits Roadblock

Some analysts had speculated Berlusconi’s Forza Italia could abandon its right of centre coalition partners in favour of a grand coalition with the outgoing Democrats, which are led by former PM Matteo Renzi, if the opportunity presented itself.

However, Forza Italia received just 14% of the vote which, when combined with the 19% held by PD, leaves a potential grand coalition of moderates with even less support than the grouping of more right leaning parties the party has already committed to.

As a result, and regardless of the eventual composition of Italy’s government, the anti-Euro, anti-migration and anti-establishment parties now hold the balance of power.

This will be unwelcome news for some because many had come to expect the election of President Emmanuel Macron in France and a new grand coalition government in Germany would clear the way for another bout of integration in Europe.

Common budgetary as well as security and defence programs are all on the cards but deadlock in Italy, followed by a Eurosceptic government, could now threaten all of this.

 

Euro Safe For Now but Risks Remain

The Euro was one of the brightest stars of the currency market in the last year, after rising more than 16% against the US Dollar on a 12 month horizon while also notching up double digit gains over other currencies like the Canadian, Australian and New Zealand Dollars.

This uptrend will remain intact for the time being, according to BMO Capital Markets, although if an anti-establishment coalition government that wields a majority were to emerge from the forthcoming round of negotiations, this could soon change.

Both M5S and the Lega have advocated anti-Euro positions over recent years only to abandon their calls for referendums on the single currency during the months leading up to Sunday’s election.

A coming together of the M5S and Lega anti-establishment parties in a coalition government would be the worst outcome for markets, according to Stephen Gallo, head of FX strategy at BMO Capital Markets. This echoes sentiments expressed by Capital Economics.

“Such a government is theoretically possible, as noted in bullet 2) above, but it would require M5S and LN to break their pre-election promises and form a coalition. As a result, an anti-establishment government is still a tail risk scenario, and this explains why the Euro and Italian assets are only moderately lower this morning in London,” Gallo writes on Monday.

“However, I also noted in my pre-election piece that even with an anti-establishment government in power, there is no immediate and clear path towards an EU/euro referendum for Italy. This is crucial for the EUR in the short-run, and it leaves the medium-term uptrend intact.”

Gallo and the BMO team assign only a 10% probability to the idea that Five Star will enter coalition with Lega. They assign a much higher 50% probability to the idea that Lega, Forza Italia and a handful of other parties will scratch together an agreement and sufficient majority to form a viable government. New elections are the second most likely proposition, according to BMO, with a 40% probability that Italians return to the polls over the coming months.

“I am sticking my neck out and arguing that M5S will stand by its pre-election promises and refuse to govern in a coalition with another party,” Gallor writes.

“Given 1) the positive cyclical momentum in the economy, 2) the degree to which coalitions dilute party platforms and 3) the need to wait and watch how Brexit plays out for the UK, I think M5S will find more strength being in the opposition than in the government at the current juncture. This result would fit with my general thesis, which is that Italy is a long-term, slow-burning issue for the Eurozone.”

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