It’s been nearly two months since Italians went to the polls, but government formation remains elusive. As negotiations continue, the chances of a repeat election are rising, possibly preceded by a transition government tasked with passing the budget in the fall and approving a new electoral law that would deliver a clearer winner at the next election.
The delay in forming an Italian government is not surprising. The 4 March vote was split across three largely incompatible political blocks: the centre-right, led by the populist Lega (formally Northern League) and Forza Italia; the anti-establishment Five Star Movement (M5S); and the centre-left, led by the Democratic Party.
What has been surprising is the market’s cool reaction to Italy’s political uncertainty, and more importantly the prospect, raised at several points over the past few weeks, that a government could be formed with the anti-establishment M5S at the helm. We have defined such a development in the past as a tail risk for the markets.
Why so calm?
We think several factors help explain the market’s acceptance of Italy’s predicament:
- Investors see that the eurozone and Italy are experiencing a cyclical uplift in growth, and do not expect macro accidents in the near term (despite some cooling of growth momentum in Europe of late).
- Markets have become used to unconventional politicians and political events (Trump’s election and Brexit, for example) and have watched global growth continue largely unabated.
- M5S has moderated its views significantly since its inception, dropping its eurosceptic stance and moving toward becoming an establishment party.
- The European Commission and Eurogroup are expected to tame fiscally irresponsible parties through their surveillance framework, placing limits on any fiscal loosening that M5S or other parties could implement.
- Investment alternatives are lacking. At around 125 basis points (bps) over German bunds, Italian government bonds (BTPs) offer a decent potential return in the context of compressed credit spreads and elevated equity valuations.
Focus on Five Star
The perception of a genuine shift in the M5S is perhaps the most interesting development. Party leader Luigi Di Maio (one of the more moderate voices) has solidified his leadership position, generally prevailing over the more radical views of party founder Beppe Grillo. Di Maio has talked constructively about Europe of late (despite the desire to reform its fiscal framework), and has ruled out forming an alliance with Lega on an anti-euro basis. His openness to forming a coalition with the moderate Democratic Party also signals a move toward the establishment.
Still, M5S is a new and unpredictable political movement, so we think caution remains justified. The formation of a government led by the party (before or after a new election) would at minimum raise uncertainty over the Italian political outlook and would likely have a negative impact on BTPs and other Italian assets. But there is also a good chance that, in government, M5S could continue its shift and become a more mainstream political party, particularly if the economic expansion continues.
Similarly, if Lega were to form a government, the negative impact would likely not be particularly severe, despite its eurosceptic rhetoric, as it would need the support of more moderate parties (most importantly Forza Italia) to lead.
On balance, our investment views on Italy are largely unchanged. Near-term risks from macro and political developments look contained, but medium-term challenges stemming from high public debt and low growth potential in the context of a still shaky eurozone governance infrastructure remain. We remain broadly neutral on BTPs in our portfolios.
For more on the eurozone, please see our outlook, “Economic Growth Masks Underlying Fragility.”
Nicola Mai is a PIMCO portfolio manager and leads sovereign credit research in Europe.