Olly Russ

Italy – don’t mistake a negotiating tactic for a genuine attempt to leave the euro

Olly Russ

The recent Italian elections ultimately produced the most unlikely of populist coalitions between the anarcho-Green 5-Star Movement and the (formerly Northern) League of the right.  No one really expected this as a potential outcome, due to the two parties’ diametrically opposing beliefs (in UK terms, the nearest parallel might be a coalition of UKIP and the Greens). 5-Star is more concerned with alleviating poverty in the south via increased benefits, while the League until recently advocated withdrawal of the whole rich North of Italy and abandoning the south to its fate. 5-Star’s leader had in fact ruled out such a pact before the elections, and so the whole series of events has been a stark reminder – if any were needed – of how fluid politicians’ principles can be.


The coalition agree fundamentally on very little, but one area on which there is common ground is a dislike for Brussels and the strictures placed on the Italian budget by the EU. The exact relationship of each party to Europe and the euro is complicated, and frankly uncertain, but it is fair to characterise them as more Eurosceptic than most, although there seems to be no serious intention of leaving either the euro or the EU itself. The coalition’s first choice for Finance Minister (vetoed by the President) was an outright Eurosceptic, but the ultimate holder of the post, Giovanni Tria, has already stated that there can be no question of leaving the euro.


Nonetheless, markets were spooked by the sudden resurgence of euro break-up talk, with apparently Italexit (or my personal favourite UscITA) on the agenda once again. This is perhaps a misunderstanding of the new government’s agenda. Nonetheless, the spread of Italian government yields over Bunds rocketed, and the Italian stock market was badly hit, dropping almost 13%. Initial coalition documents (since abandoned) talked of Italian debt forgiveness from the European Central Bank of €250bn, something of a tall order to sneak past the ECB Governing Council, even with an Italian Chairman. Moreover, the legislative programme talked of moving to a flat tax system (a League idea) and a universal basic income (5 Star’s big idea). Neither of these ideas comes cheap – Italian broker Intermonte estimates €50bn for the tax idea and €17bn for the UBI. Investors panicked at the prospect of a major eurozone country going rogue and using deficit financing for unsustainable public spending. Italy already has the second largest pile of eurozone debt to GDP after Greece at c.130%, and the largest absolute amount of any eurozone country. Truly, Italy is too big to fail, or indeed to be rescued.


Italy is not Greece however. It carries far more clout in Brussels due to the size of its economy. Its deficit in 2019 is projected to be less than 1%, and Italy in fact runs a very healthy primary surplus (i.e. before debt costs, currently c.3.5% of GDP per annum) of 1.9%. Under the previous government’s budget proposals, the deficit would be down to zero in 2020, and indeed as growth returns the debt to GDP ratio has already started to reduce.


So while Italy’s opening position is far from ideal, the dynamics are in fact very much more favourable. Most of Italy’s debt relates to the 1990s, and relatively little was added during the financial crisis compared to most other major nations. However, Italy’s key problem has been its abject growth record within the euro. If we consider economic growth in the 21st century, no less than three eurozone countries rank in the bottom 10 globally, alongside names such as Yemen, Zimbabwe and the Central African Republic. Italy has managed to grow in real terms by a staggering 1% in 16 years, leaving the purchasing power of its residents well below that of northern eurozone peers. Perhaps it is surprising there has not been more populism in Italy. Yet this unhappy fate cannot be laid entirely at the door of the euro – Ireland, Luxembourg, Spain, Germany and Finland have all done much better within the single currency. The real problem is lack of competitiveness within the euro, which requires labour market reforms and an internal devaluation (i.e. wage cuts) as Spain has seen, but to which Italy has been very resistant. Had Italy grown more like Spain, its debt/GDP ratio would probably be sub 100%, even now.

Since the old economics has manifestly failed Italy, perhaps voters are justified in trying a new approach. The 5-Star Universal Basic Income sounds like another unsustainable handout but in fact is (so far as there any figures at this stage) relatively modest, calculated on a household basis, and limited in time to two years. This could boost spending in the generally poorer south. But the flat tax plan (technically not quite a flat tax as it has two bands of 15% and 20%), which applies to individuals and corporates, has much more potential. It will be counter-balanced by removal of various allowances, but essentially marks a significant shift in fiscal policy towards a general lowering of the burden and a great simplification of the tax code. Increased compliance with this lower burden may yet make up some of the shortfall. It is perhaps worth noting that in the UK the cutting of corporation tax was posited to reduce tax take: in fact corporation tax receipts were nearly 50% higher than predicted five years ago by the OBR for 17/18 – a mere £19 billion discrepancy per annum – Reaganomics at work?


In the somewhat complex and fast-moving world of Italian politics, it is notable how the smaller party, the League, seems to be driving the government agenda. The League secured only 17.7% of the vote, compared to 5-Star’s 32.2%, yet the League’s head, Salvini, seems to be making all the running. In fact, the League has just nosed ahead of 5-Star in recent opinion polls, showing it has been the big winner of the electoral process so far. This is worth bearing in mind, because if the government collapses at some future stage in disorder (and it wouldn’t be the first time), a repeat League/5-Star coalition would be impossible, and then the most likely outcome would be a League-dominated coalition with Forza Italia (yes, the Berlusconi party again).


In the short term, tax cuts could be just the stimulus the Italian economy needs to begin to fire up properly. However, as noted above, these tax cuts have short-term fiscal implications, and this brings us back to Europe and the anti-EU rhetoric. It is true that opposition parties tend to be far more Eurosceptic than when they transition into governments. The same is perhaps true even with the new coalition. While heads of both houses of parliament have recently been selected from the Eurosceptics, we think this is best viewed as part of an elaborate negotiation. Italy has no intention of leaving the euro – such a venture is impossible without large-scale financial crisis, which would bankrupt Italy and entail large sovereign defaults. However, if one were desirous of more EU flexibility on budgets – say allowing a 1% deficit instead of a balanced budget in 2020, alongside more monetary help with migrants, currently estimated to be costing Italy €5bn per year - then one might as a negotiating tactic choose to raise as many grievances as possible with Brussels with the aim of securing concessions, a lesson Theresa May might care to observe closely. This, combined with sharp tax cuts to provide economic stimulus, seems not unreminiscent of another US president, with whom the current Italian government apparently seems to be on good terms. Whatever the medium-term implications, it seems a short-term fiscal stimulus has the potential to do Italy – and by extension the economy and markets – a great deal of good. For this reason, we think markets have mistaken a negotiating tactic for a genuine attempt to leave the euro.


Italy’s 12m forward price-earnings at c.20% discount to European average

Italy – don’t mistake a negotiating tactic for a genuine attempt to leave the euro 

Source: Thomson Datastream, UBS European Equity Strategy


The broad based sell off seen in Italian shares since May has priced in a level of negativity that is, arguably, overly excessive. Currently priced at a 20% discount to Europe on a forward price/earnings ratio basis, Italy has not been priced at such a level since around the time of the constitutional referendum and, before that, the financial crisis of 2009. If attempts to leave the euro are being used solely as a negotiating tactic, this has certainly left a number of Italian companies looking particularly cheap. As a case in point, Intesa Sanpaolo, which is the largest and best capitalised bank in Italy, and has benefitted from acquiring attractive assets at nominal costs as part of the broader Italian bank clean up, currently trades on an 8% dividend yield. This dividend is both highly secure, and expected to grow. It would be expected that this recent period of underperformance for Italian stocks will begin to reverse as the true intentions of the coalition become clearer to the market.


There will no doubt be continued rumblings over the summer and beyond – especially as the autumn EU budget rounds commence. But we think Italy should get a better budgetary deal than it is currently permitted – and, on this at least, 5-Star and the League are firmly of one mind.

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Thursday, June 28, 2018, 11:01 AM