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What Italy’s new government means for the eurozone

The populist Five Star Movement and The League are on the cusp of forming a coalition government in Italy. As both parties have been vocal with their anti-EU rhetoric, this is a crucial moment for the eurozone’s third largest economy and the bloc itself.

Over two months of a political stalemate are coming to an end with little-known professor Giuseppe Conte being nominated as Prime Minister to President Sergio Mattarella. The President is expected to formally announce the name of new Prime Minister soon.

Despite being a political novice with limited direct experience, Conte was nominated by both parties as being an impartial, balanced candidate that could represent both the Five Star Movement and League.

Although both Five Star and the League are riding the wave of populism, there are obstacles to overcome in regards to agreeing on policies. Both Luigi Di Maio from the Five Star Movement and Matteo Salvini from the League will have burnt the midnight oil over the weekend to reach a compromise over the new government policies.

Political risk in Italy

Financial markets have started to take notice of the political noise, and credit ratings agency Fitch has warned that Italy’s new government poses a risk to the country’s credit profile. Political risk was a key reason why Fitch downgraded Italy’s rating  to BBB last year, and it’s said it’s keeping an eye on the political scenario and loosening of fiscal policies.

Whilst both parties have been vocal with their anti-EU rhetoric, the raft of policies announced isn’t designed to rip Italy from the bloc just yet.

This doesn’t mean that an overhaul of EU fiscal, monetary and single market rules isn’t high on their agenda, along with rewriting trade deals and renegotiating the EU’s seven-year budget.

With Italian debt to GDP at 130%, Italy’s debt is the highest in the eurozone – aside from Greece. Unfortunately, policies designed to cut taxes and spend more won’t help improve that ratio.  

Immigration policies look to review and reform Italy’s role in the migration of people to Italian ports, and a radical review of EU banking rules is on the cards. Sanctions on Russia should also be lifted, the policy book declares.

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How have financial markets reacted?

If we rewind to election day more-than two months ago, we predicted that this populist pairing would majorly disrupt the financial markets. It took some time, but the financial markets have finally woken up to the political risk of a new populist anti-EU government with an inexperienced prime minister at its helm.

The previous relaxed nature of the financial markets was probably hinged on them assuming any radical policies would be softened once the parties were in government. Although this disappoints the populist fringes, it reassured financial markets.

Sentiment has switched, however, and the ten year spread between German and Italian bonds is climbing at its steepest rate since 2013, rising for three consecutive days to 180 basis points – the highest level since mid-2017. This steep climb reflects a hectic few days of activity on Italian financial markets.

The possibility of a real change in policy in Italy is quite small, but it’s fair to say that a proper crisis would likely be negative for risk asset generally, particularly in Europe. The Euro could weaken, potentially triggering a sell-off in European equities.

Some might argue that the euro sans Italy would be a stronger currency, but there’s a real risk the Eurozone could be pushed into recession as a result.

Then again, markets aren’t infallible and have been known to make mistakes in the past.

The Moneyfarm portfolios don’t have a lot of direct Italian exposure, although our European fixed income ETFs inevitably hold Italian government bonds. We aren’t too concerned by this and we’re not looking to make changes to our portfolios in response.

Election risk can easily be managed through global diversification. By spreading your money across different investments from different countries, you hope to offset any short-term politically driven fluctuations with gains made elsewhere.

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