Politics remain a worry in the region after the European Parliament elections strengthened Italy's right-wing maverick, Matteo Salvini.
The elections for the European Parliament produced some interesting results and are shaking up domestic politics in a number of countries. Overall, the elections increased voter support for right-wing populist parties, but this fell short of the wave that some had expected. So, pro- European Union (EU) parties from the center — from the moderate left to the moderate right — remain a majority in the Parliament. The results are playing out in interesting ways in a number of countries, including Germany and Italy.
Germany's Green surgeIn Germany, the Green Party enjoyed the greatest increase in support at the European elections. The election upset is making Chancellor Angela Merkel's coalition government look shaky. Andrea Nahles, the leader of the Social Democrats (SPD) — Merkel's coalition partner — resigned due to party infighting over its future direction. This struggle was exacerbated by the EU elections and growing fear within the SPD that the compromises it made to join the national coalition are weakening its electoral prospects. The SPD will later this year pick a new leader and review its role in the coalition.
With Merkel on the way out, it looks possible that the end of 2019 could bring an end to the coalition, especially if the new SPD leader turns the party to the left. This set of developments does not portend an immediate shift in German domestic policy or European policy, but it does illustrate that Germany is not immune to the political stresses evident elsewhere in Europe. For now, the Christian Democratic Union and the SPD are too weak to walk away from the coalition. This arrangement, however, is not stable over the long run.
Italy's League party comes ahead in EU electionsIn Italy, the strong showing by Deputy Prime Minister Matteo Salvini's League party had the expected effects: Salvini has started to express himself more openly and is trying to assert his own priorities within the coalition. The comparatively weak performance by the 5 Star Movement in the EU elections has caused its leader, Luigi Di Maio, to cede some ground to Salvini. Broadly speaking, the League has doubled its electoral support, and 5 Star has seen its support halved. This is a simple, straightforward message, and it is easy to see its electoral appeal. Lower, simpler taxes would be popular with pretty much any electorate, and the idea that European rules are holding Italy back is popular with the League's base. The real question is how far Salvini is willing to push against the eurozone's orthodoxy. Over the past year and after a number of missteps, the government has found a way to make some fiscal expansion, but not enough to alienate the EU, undermine the BTP (bonds offered by the government) market, or weaken the sovereign credit rating.
This dance is now starting up again, but the music is a little different. First, the economy is weaker than the government expected. First-quarter real GDP growth was revised down to 0.1%, following a contraction of 0.1% in the fourth quarter. Nominal GDP growth has been running at below 1% year on year. This has placed some strain on the debt-to-GDP ratio. Finance Minister Giovanni Tria has blamed the slowdown on the external environment and not on any fiscal slippage on the part of the government. The EU has taken note and started an excessive deficit procedure (EDP), an action by the European Commission against any EU member state that exceeds the bloc's budgetary deficit ceiling. This is a long process and inevitably highly political, and at the end of the day it may not amount to very much in and of itself, but it will raise the political temperature a little and it will give Salvini a punching bag. The key issue is the effect it has on Buono del Tesoro Poliennale (BTP) yields. Salvini's rising political clout is also an important change. He is making demands that seem increasingly likely to result in early elections.
The real question is how far Salvini is willing to push against the eurozone's orthodoxy.
Room for missteps and market volatilityWe don't think Salvini and his advisors believe that departure from the eurozone is feasible. But we also believe they are serious about making a sustained effort to relax the eurozone's fiscal rules as a second-best way to recapture some policy autonomy. This is not going to be an easy battle to win; we doubt they will get much more than a token or two.
But there is clearly a significant risk of market volatility. If Salvini decides to cause a collapse in the government to usher in new elections, we expect some volatility in the markets in the near future. That volatility may continue if he wins and a new government drafts the budget for 2020. We expect the dance to end the way it did last year, with the financial markets acting as the disciplinary force on the government's ambitions and the government stepping down. But we have to get there from here, and there are many opportunities for missteps along the way.