Equity Outlook  |  Q4 2018

Italy's policy standoff

Simon Davis, Co-Head of Equities, and Shep Perkins, CFA, Co-Head of Equities

Italy's policy standoff

Italy continues to generate political risks for equities. The Italian governing coalition consists of two major populist parties that have combined to form a relatively fragile alliance. The coalition is working to enact a budget that risks pushing debt to an unsustainable level and that would conflict with the rules of the European Commission and fiscally conservative nations of the European Union (EU). It raises fears of sovereign risk within the eurozone and a potential "Italexit" — a play on the term "Brexit" — in reference to a departure of Italy from the EU.

We believe these issues pose a threat to Italian assets and potentially to the integrity of the EU. The populist government's combative stance toward EU policies has triggered a sell-off in Italian sovereign bonds and pressured Italy's bank stocks. Italy is a large economy with a debt of more than $2.5 trillion, and if a crisis were to unfold there, it would have far-reaching effects — greater than the impact of the crisis in Turkey today or in Greece during 2012.

The parties are proposing policies that imply fiscal expansion through a flat tax reform, pension reforms, and minimum income guarantees. We find it difficult to see how the government, in the face of dwindling economic growth and budget surpluses, can manage this without expanding the nation's debt-to-GDP position.

Early in the fourth quarter, pressure on Italian assets intensified after the government announced a budget deficit target that EU authorities believe would break the EU rules on fiscal discipline.

The proposed budget-deficit target of 2.4% of gross domestic product would contravene both the Italian constitution and European Commission requirements. Given these factors, the populist coalition will have to decide whether to fight for the policy that got them elected or accept a diluted policy. Recent rhetoric from the populist coalition has not been supportive of a compromise, with the finance minister going so far as to suggest a change to the constitution. However, a constitutional change is unlikely, as it is more in keeping with Italian political precedent to find a muddle-through compromise.

Although Italian and European equity markets have already begun to price in some of these risks, we have concerns about the continued pressure on Italian assets and the impact to global markets if the situation were to deteriorate.

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