Italy's Political Upheaval Resurrects Crisis-Era Ghosts

Markets’ reaction to the latest in Italy’s political drama went global on Tuesday, as the S&P 500 reopened after the holiday weekend and promptly sank. As US investors enjoyed some Memorial Day cookouts while honoring veterans and fallen soldiers on Monday, European stocks tumbled as they digested the news of Italy’s collapsed coalition government. The slide gained steam on Tuesday, with Italy leading the way down. Meanwhile, Italian bond yields jumped while yields elsewhere in the developed world plunged, in a sign of an apparent flight to safety. In our view, this reaction seems excessive. While uncertainty is heightened, Italy’s economic and political fundamentals haven’t flipped. The country still faces gridlock, and despite the prospect of new elections, the likelihood of a populist government gaining enough power to leave the euro remains exceedingly low.

Given how quickly Italy’s political scene has evolved in recent days, there is a risk any synopsis we publish now will be outdated in days. But here goes anyway. Last week, it looked like the populist government proposed by the hard-right party, the League, and antiestablishment Five Star Movement (M5S) would become reality, fulfilling investors’ worst fears. Accordingly, Italian stocks had a rough week as President Sergio Mattarella blessed the coalition’s pick for prime minister—Giuseppe Conte, an academic whose resume included some, um, unverified educational claims—and party leaders unveiled more cabinet picks. Bond yields also jumped as investors grappled with an incoming government they feared would blow deficits sky-high. But over the weekend, progress came to a screeching halt. Mattarella vetoed the coalition’s choice of finance minister—a staunch euroskeptic named Paolo Savona—creating a backlash as M5S and the League refused to put forth another candidate. Their partnership dissolved, so Mattarella nominated Carlo Cottarelli, a former IMF official, as technocratic prime minister of a caretaker government. If he wins a confidence vote, Cottarelli would have the mandate to create a budget and guide Italy to another election next year. However, both populist parties oppose this, and Silvio Berlusconi’s center-right Forza Italia has also refused to lend its support. So, presuming Cottarelli loses the confidence vote, Mattarella will likely dissolve parliament and call new elections, which would probably occur by September.

Many fear this chain of events will hand the populists a plump victory on a silver platter. M5S leader Luigi DiMaio and League leader Matteo Salvini are already decrying Mattarella’s intervention. They claim credit spreads, not voters, are now deciding the country’s fate. Some colorful headlines have called it a coup d’etat by eurocrats—and, by extension, from Brussels itself. The League has already gained in opinion polling since the last election, and many fear a public backlash against “getting played” by the establishment could tilt the advantage strongly toward the populists—who would in turn catapult Italy out of the euro and usher in the mother of all debt crises.

Yet it seems highly unlikely this worst-case scenario plays out as expected. The League-M5S partnership was odd to begin with, and they may not team up for the next elections. With its strong leftist faction, M5S was always an unnatural coalition partner. It and the League agreed on little beyond a shared hatred of the establishment. Large swaths of M5S despised the League’s pledge for a flat tax, for example. After the coalition collapsed, it took about three nanoseconds for Salvini and DiMaio to resume bickering. Many suspect the weekend’s events are a case of opportunistic political posturing by the League, which has intermittently argued for new elections for weeks. They could feasibly do well enough in a snap vote to partner with their original choice, Forza Italia, on a right-leaning government. If that were to happen, the policy agenda would likely differ radically from the populists’ plans—and could very well resemble something much more traditional. It might also improve the likelihood that proposed flat tax actually becomes reality—a potential long-term positive for the nation, as some have noted recently.

While that is just one of many possible outcomes, the likelihood of Italy exiting the eurozone remains low in the near term. To exit the monetary union, parliament must amend the Italian constitution. That requires a two-thirds vote in parliament. It seems unlikely an Italexit^[i] measure could garner this much support presently, particularly since the antiestablishment M5S isn’t universally anti-euro. Additionally, Italian popular support for the euro has been a bit over 50% over the last year (depending on the poll). Many Italians may also realize any sudden departure from the eurozone and devaluation of the country’s currency would be extremely painful for Italy’s citizens, with over two-thirds of Italy’s large government debt held by residents, one of the highest ratios in Europe. For these reasons, if voters see a new election as a referendum on euro membership, it could be a headwind for the League and M5S, which distanced themselves from such rhetoric before March’s vote.

In our view, the sharp reaction to this news highlights how dour sentiment is towards Europe. It doesn’t take much to resurrect ghosts of the debt crisis and send fear soaring again. What few realize is that even with Italy’s 10-year yields jumping on Monday and Tuesday, the country can still refinance long-term debt at cheaper rates than when the bonds were issued a decade ago, making debt service cheaper and further reducing the risk of problems in the near term. Overall, we see ample room for uncertainty to fall as investors gradually realize this won’t be the end of the eurozone or Italy’s membership in it. As the dust settles and the fog lifts, the resulting falling uncertainty should buoy eurozone and Italian stocks.