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Economic Insights

In any case, strife between the EU and Italy would cause a greater risk premium to be priced into Italian assets, starting with a wider sovereign spread to German Bunds.

Italy is in a quandary after the election on Sunday (March 4). If a governing coalition can be formed, it is likely to favor fiscal expansion after many years of austerity, even though relaxed fiscal policy is barred under Italy’s treaty obligations unless waivers are granted. If the fiscal conservatives in the European Union (EU) instead demand even more austerity from Italy—a seemingly reasonable thing to ask for, considering that gross government debt outstanding has risen to more than 130% of gross domestic product (GDP)—the standing of the EU in Italy could plummet further, leading to an intense debate over potential withdrawal from both the common market and the single currency.

In Sunday’s election, there was a significant shift away from “establishment” parties of the center-right and center-left—from 47% of the vote in 2013 to 34% in 2018—and toward insurgents. Five Star and the Northern League garnered 29.7% of the vote in 2013 and 51.4% in 2018. Five Star was strongest in southern Italy, while the League got most of its support in the north. The two insurgents also appear to have garnered most of their support outside the largest urban areas and among the “non-elites,” i.e., less-educated and lower-income voters.

The Northern League’s remarkable electoral result parallels the surge in immigration as one of the issues of greatest concern to Italians (see Chart 1). This concern goes hand in hand with the Syrian refugee crisis that most countries in the region have struggled to deal with. In Italy’s case, it is further complicated by the simultaneous increase in migrants from North Africa. The League was founded on a program of Italy for the (Northern) Italians, so they received backing from those who blamed established parties—and the European Union—for responding ineffectually as immigration increased sharply.

Five Star benefited from proposals to institute a minimum monthly stipend for all Italians and an end to fiscal austerity more broadly. Clearly, these changes appealed most in regions where unemployment is highest and where the economic recovery from the 2008–12 crisis has been relatively feeble.

By offering few new approaches to the two most pressing problems facing the country and believing that a nascent economic recovery was proof that the economy was on the right track, establishment parties lost credibility and opened the door to insurgents that addressed the key issues more forcefully, even if the solutions they offered will prove extremely difficult to implement.

 

Chart 1. Unemployment and Immigration Have Surged in Importance in Recent Years

Source: Eurobarometer, as of May 2017.

 

Given the number of seats Five Star controls in the Senate and Chamber of Deputies, it will be very difficult to put together a governing coalition without its involvement. The only possibility is a center-right grouping cobbled together out of the League, Forza Italia (Berlusconi), FdL (far-right nationalists), and defectors from other parties. This would be treated, at least initially, as a market-friendly government. Otherwise, Five Star could align with the Northern League—a coalition that was thought of as a low probability nightmare before the election—or the Democratic Party (PD).

Now, the only reason a coalition with the PD is possible is because its leader going into the election, Matteo Renzi, has resigned. A Five Star–PD coalition also would be seen as market-friendly. If none of these arrangements coalesces, a technocratic government with limited duties could be installed. Its main task would be to pave the way for a new round of elections.

If a coalition does come together, it is very likely that it will demand an end to fiscal austerity. The problem with this is that after a severe economic downturn and a halting recovery, Italy’s gross government debt outstanding is more than 130% of GDP (see Chart 2), which obligates it to cut spending or raise taxes under various treaty obligations. The European Commission would have to grant Italy a waiver to avoid mandatory policy tightening. Of course, easing up on fiscal restraint, while debt outstanding is more than double the 60% ceiling envisioned by the Maastricht Treaty, would give lots of ammunition to those who are looking for ways to loosen economic ties between countries in the EU rather than binding them together more closely as Macron and the Social Democratic Party of Germany have proposed.

 

Chart 2. Italy’s Gross Government Debt Outstanding Is More Than 130% of GDP

Source: International Monetary Fund and Bloomberg.

 

The thing that makes it even more difficult to find a solution that a new Italian government and its EU partners can live with is that Italy has, in fact, been pursuing fiscal austerity for many years, with precious little to show for it. Italy has been running primary (net of interest payments) budget surpluses since the early 1990s. This permitted debt outstanding to drop, from 127% of GDP in 1994 to 100% of GDP in 2004. Even as debt outstanding started rising again in 2008 because of the global financial crisis, Italy maintained a primary surplus of 1–2% of GDP in most years. (See Chart 3.)

The primary surplus can be thought of as a tax on a nation’s standard of living, a levy to make up for past profligacy. Large primary deficits are very difficult to maintain for long periods of time, especially under conditions of slow GDP growth. Thus, Italians have been remarkably disciplined for many years, but their sacrifices have been met with a worsening debt position. This makes it extremely difficult to implement further tightening measures, even if this is what is required of Italy under the Maastricht and Lisbon treaties, and very easy to convince voters that they deserve a break.

 

Chart 3.  Italy Has Maintained a Primary Budget Surplus of 1–2% of GDP in Most Years

Source: Organisation for Economic Co-operation and Development, and Bloomberg

 

As Italy has struggled to meet its requirements under the single market and single currency, and as the EU has struggled to come up with a solution for immigration that is acceptable to all member countries, support for the EU among Italians has eroded sharply. (See Chart 4.) After being among its staunchest supporters in the early 2000s, Italians are now less enthusiastic about the EU than the average citizen in other member nations. Thus, if a new Italian government is blocked on economic or immigration policy by the EU, the strictures will be particularly difficult to bear and chatter about “Exitaly” will get louder and louder, no matter how inconceivably difficult, and costly, that would be.

Note that while the balance of Italians in favor of the single currency has come down sharply, it is still supported by 25% more people than it is opposed by. This is in line with the EU average, even though net support for EU institutions is lower in Italy.  

Strife between the EU and Italy would cause a greater risk premium to be priced into Italian assets, starting with a wider sovereign spread to Bunds. Thus far, the market has not taken this risk seriously, as expressed in a more or less stable credit default swap spread in recent days. Considering how resilient eurozone institutions have proven to be in recent years, it is probably correct to assume that a path for Italy to pursue its national interest within the current framework will be found. However, the Brexit example shows that elegant and rational solutions to difficult problems sometimes prove elusive, even for countries that have been under less stress than Italy has been in recent years.

 

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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