Political risk increases and markets remain complacent in Italy

The Five Star Movement (M5S) and Lega are entertaining the possibility of forming a coalition government after Mr. Berlusconi agreed not to participate in its formation and to abstain when the confidence vote takes place in Parliament. Ongoing discussions between the two parties are now focusing on their choice of both a potential Prime Minister and government ministers, and on the policies this government would pursue. The two parties should report back to the President of the Republic within a day on progress made.

It is still highly uncertain whether an agreement can be reached and more clarity is likely to come by the end of the week. In the event of failure, the President of the Republic will nominate a caretaker government and new elections will take place in the coming months.

If Five Star – Lega’s attempt to form a government succeeds, this coalition will have been the least expected outcome going into the the elections. But, in our opinion, this was and remains the outcome that would likely be viewed as the most negative by the market.

Since the general election took place on March 4, news around political developments have been incrementally negative, but the market has remained complacent in pricing political risk in Italy. So far, the market reaction has remained remarkably muted even though the prospect of a Five Star – Lega government has increased. As our thinking, carry considerations are being balanced against political risk. From an economic perspective, however, if the political manifestos of the two parties are any guide to the policies that a Five Star – Lega government would pursue, the upcoming budget law for 2019 would consist of lax fiscal policies that would (i) lead to the deterioration of the public finance outlook and prevent a decline of the stock of public debt, and (ii) increase the probability of ratings downgrades. Moreover, if lax fiscal policies were to be pursued, leading Italy to breach the 3% deficit rule, these policies would create tensions with the European Union and be a source of disagreement with the European Commission. Even if Five Star and Lega have toned down their anti-European rhetoric, tensions between Italy and European partners would also certainly complicate the efforts at the EU level to make further progress on EMU integration.