Italian government crisis explained: Political timeline and market outlook

August 12 2019

Giles GaleHead of European Rates Strategy

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Imogen Bachra, CFAEuropean Rates Desk Strategist

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A political crisis in Italy is now in full swing. When will there be an election? What impact does this have on the outlook for the Italian economy and markets?

Crib sheet: Italian politics

  • Giuseppe Conte is the Prime Minister of Italy and is the head of the populist government.
  • The government is a coalition between two parties: The Five Star Movement (M5S) and the Northern League (League).
    - M5S is a left-leaning anti-establishment party led by Deputy Prime Minister Luigi Di Maio
    - The League is a right-wing party led by Deputy Prime Minister Matteo Salvini

  • The parties came together despite largely incompatible views. Their relationship has become increasingly fractured recently, disagreeing on multiple issues including tax reforms and justice.
  • The main opposition are the Democratic Party and Forza Italia.
  • New elections must be called by the President, Mr Mattarella. Late October is possible the timing.

#crisigoverno: What led to Salvini’s threat of divorce?

The two coalition partners have clashed increasingly frequently in recent weeks, notably over spending priorities and representation in ministries as the League – the smaller partner in parliament – tried to turn its greater current popularity into increased influence.

This long fuse came to its end following a vote over Italy’s proposed high-speed railway TAV on Thursday 9 August, which the League favours and the M5S does not. Mr Salvini called for an end to the coalition and for new elections. His party followed up by submitting a no-confidence motion to the Senate. The date will be set on Monday 12 August.

Salvini’s motivation is clear – Prime Minister

In our view, the motivation for Mr Salvini’s move is clear. According to opinion polls, his popularity has been rising rapidly in recent weeks. Polling averages put his party on 38%, up 6% from May[1]. The League’s improvement has been largely at the expense of M5S and Forza Italia.

If these polling figures were reflected in a general election it is possible that the League could win a majority because one third of seats in both houses of parliament are decided in a first-past-the-post system. But from the League’s perspective, the sooner the elections come, the better – political fortunes in Italy have a history of being volatile.

Will there be an election and if so, when?

The developments over the last week mean that new elections are now no longer our base case. Over the weekend, Matteo Renzi (of centre-left party PD) threw a spanner in the works of Salvini’s early election plan by suggesting that his party should consider a government with M5S. This development was unexpected, given he had previously blocked such a grouping in the negotiations last year. We now expect (with a 75% probability) that new elections can be avoided in Italy, at least in 2019. We think there is a 55% chance that PD and M5S form a coalition, and a 20% chance that Salvini in fact makes a U-turn on his threat of divorce, and the current coalition continues to govern.

What does this mean for markets? Expect volatility

Stock and bond markets, which tend to value stability – and are suspicious of Mr Salvini’s Euroscepticism –  were shaken by his call for a new election. Much of the reaction came on Friday 9 August, immediately after the announcement, but risk had been building slowly as political tensions were running high. Italian stock markets fell sharply. Italian banks in particular struggled against the weight of the news, and this has affected European stock markets more broadly.

Chart 1: 10-year Italian government bond yields spike up before recovering again

Source: Bloomberg, data as at 15 August 2019.

Watch out for Italian government bonds

The interaction between Italian politics and pressure from investors in its large government debt market has been a real feature of the political landscape in recent years.  Italian government bond markets are typically very vulnerable to Italian political risks. And this time it has been no different with yields on Italian 10-year government bonds spiking upwards between 7-9 August, as you can see in chart 1. However, bond markets have since recovered, with yields falling back to pre-government crisis levels.

However, this is not a one-way relationship. Markets have been challenging for the Italian government over the past year and investors have been demanding more compensation for the high level of risk that they have had to take, when compared to investing in government bonds from Italy’s peers.

Avoiding fresh elections (and a M5S+PD government) would be the most market friendly outcome from this political crisis for Italy, so we would expect some of the political pressures in the market to alleviate over the coming days and weeks.

That said, political fortunes can change very quickly in Italy – as the last few days have demonstrated – and we do not discount further twists in the narrative as this political crisis unfolds.

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