By William Davies, Head of Global Equities, Threadneedle Investments
A Mandate for Change
The current focus from the Italian election is on personalities, the rise of a new political force and the challenge facing the Italians to form a new government. I believe we should be looking beyond this. The vote against Mr Monti and austerity puts any Italian government, should it get formed, at odds with policies still followed across the Eurozone. Italians offered their politicians a clear mandate for change. They voted for stimulus, not austerity and we should question whether the ‘OMT put’ should apply to Italy when their government would have no mandate to accept any potential conditionality. Hence unless Europeans relax their fixation with austerity and budget targets, the increase in risk brought about by the Italian election result resides across the Eurozone, not just in Italy.
The Italian elections have caught the headlines, what with the emergence of the anti-establishment Five Star Movement under Beppe Grillo (25.6% of votes), the re-emergence of Silvio Berlusconi and his People of Freedom (29.2%) and the crushing of the Prime Minister, Mario Monti – Civic Choice (10.6%). The effect of the result is to give a majority to the centre left Democratic Party (29.5%) under Pier Luigi Bersani in the Chamber of Deputies, as expected, but no outright majority in the Senate, as feared. The hope had been that the Democrats, with the help of Monti’s centre grouping, would have enough seats to carry a majority in the Senate also. Alas, Civic Choice’s dreadful showing put paid to this. The conclusion of the election is that the Italian people have voted firmly against austerity and with the emergence of Grillo, against the establishment and politicians in general. So what does all this mean going forward?
To my mind we run the risk of reaching a third stage in the euro debacle. The first stage concluded last summer when bond investors drove sovereign bond yields ever higher in the weaker periphery countries, creating a self-fulfilling situation where targeted countries could no longer afford the interest on newly launched bonds to support their budgets. The second stage started last July when Draghi said he would do ‘whatever it takes’ to save the euro and we saw in September the imposition of the framework to support Outright Monetary Transactions (OMT) and common banking supervision in the euro area. It also helped that Chancellor Merkel seemed around this time to realise that this policy would more likely support her re-election in September 2013 than would the demise of the euro and the implosion of the European financial system. Hence bond investors had effectively been emasculated by Draghi. The euro could still fail, but it would take countries to decide they should leave (instead of the alternative of accepting OMT and the ECB’s accompanying conditionality of austerity and structural reform), rather than to be at the mercy of bond markets.
So what is this third stage? To me, it is the arrival of the time when countries choose to break with austerity.
First, some background - for OMT to be imposed a country needs to agree to the ECB’s conditionality which is expected to comprise austerity and structural reform. For Italy, the electorate have just given an unequivocal thumbs down to austerity. (It could be argued that we saw a similar vote in France last year but Mr Hollande does at least intend to reduce the deficit, helped by tax increases). In Italy there is no clear government as yet. I think it most likely that the Democratic Party, with its majority in the Chamber of Deputies, will form a minority government but rely on other parties to get bills through on a case-by-case basis. Hence the only bills to get through will be those agreed upon by the Democratic Party itself and the People of Freedom or Five Star Movement parties. Bersani has proposed an agenda based upon political reform, the easing of austerity and job promotion. Certainly Mr Grillo supports political reform and the easing of austerity. Mr Berlusconi is also against austerity, especially if it reverses property tax. Hence there is common ground. But haven’t we seen this before? Berlusconi as prime minister could promote growth but not pay for it. What chance the three main parties agreeing to unpopular further structural reform or increasing taxes/cutting spending to pay for their stimulus? Hence the arrival of the third stage in Italy: the easing of austerity. But what will this mean? Will the European authorities be willing to see pro-growth policies and higher deficits enacted in Italy? The IMF seems increasingly to favour growth vs austerity but the Germans in particular do not appear quite so forthcoming. Admittedly there has been slippage in deficit targets across the Eurozone but I’m not aware of countries brazenly flouting the direction of these targets – but Italy, even with no government as yet, effectively has the mandate to do this.
Currently the focus in Italy is upon their ability to form a government. Will it be a grand coalition or a minority government passing policy piecemeal? If there is a government formed following the restart of parliament on March 15, how long will it last before the parties with very different ideologies find something to disagree about and call another election? With this prospect are we back to the Italy pre-Berlusconi when elections took place most years? These questions will get answered over time but of more interest to me is the implication of the election upon future policy given that the politicians have been given the mandate for change, ie to tear up the austerity plans. Furthermore, the unstable political balance means that tax cuts and spending increases may get passed, but that it’s unlikely that unpopular or austere policies will meet with common approval. If bond investors feel such an environment is unsustainable, we should see Italian spreads widen. Pre-election, we would have expected the OMT to come to the rescue, but if conditionality still means austerity, Italy has no leader amongst the current three dominant factions who would appear to have any mandate to accept such a reversal. Without OMT we are back to stage one of the euro crisis, with bond markets dictating not only the direction of travel, but possibly the end game also.
How can we avoid such a situation? If Italian stimulus is gentle and the budget deficit is not out of kilter with other countries’, there should be no reason to target Italian bonds – after all, Italy currently runs a primary surplus. If European authorities’ views, like the IMF’s, are now less fixated about austerity and hitting targets, Italy will get more leeway. Until September this year, Mrs Merkel will presumably want to avoid Eurozone drama. She sits pretty in the polls and will not want this upset. It will be interesting to hear Mr Draghi’s views on Italy at the press conference following next week’s ECB meeting.