Italian elections: the winner doesn't take it all

Sunday’s Italian elections have yielded big wins for populist and radical forces and defeats for establishment parties. The (Northern) League has gained support on a mainly anti-immigrant platform, winning mainly in Northern provinces, while the Five Star Movement wiped out the traditional centre-left in the poorer Southern regions, where economic prospects are weak. Combined they won half of all votes. The big defeat for the incumbent centre-left Democratic Party induced its leader Renzi to resign, although he plans to stay on during the coalition talks. The preliminary seat projections indicate that a workable majority for a relatively stable coalition looks impossible.

The centre-right coalition won, but comes short of a majority with around 37% of the votes. The populist Five Star Movement led by Luigi di Maio was the party that won the most votes, with around 33% of the popular vote. The incumbent centre-left coalition headed by Renzi is at a distant third place with only around 23% of the votes. The far-left Free and Equal gathered 3.5% of the votes and is the only other single party next to Five Star to have passed the entry threshold.

With no single party or straightforward coalition seemingly able to form a government, we should prepare for some lengthy coalition talks. On the upside, in the past two years we have seen in Germany, the Netherlands and Spain that the economy can do just fine without a mandated government. Moreover, Italy has had its fair share of unstable and uncertain politics in the past. On the downside, in none of the aforementioned countries economic growth was as fragile at the time as it is in Italy, nor did populist and anti-establishment parties win as many seats as in Italy.

Prior to the elections we sketched several scenario’s. We thought the centre-right coalition would have the best shot, but only if Forza Italia would outperform the League. Next came a Grand Coalition, a caretaker government and new elections, and a populist government as a tail risk.

Centre-right fails to secure a majority and the League wins big

Besides the insufficient number of seats for a clear majority (table 1), the balance of power within the centre-right in favour of the League complicates the formation of a centre-right government. As we have mentioned before, we find it difficult to see how the more moderate pro-business party Forza Italia (FI) could operate in a centre-right coalition as a junior to the far-right League. Moreover, with the League in the lead it will be more difficult to win over any MPs from other parties (party hopping is not unconventional in Italian politics). That said, if we add the preliminary estimates of the first-past-the-post seats won by FI members to their proportional seats, the balance of power seems less disruptive than at first sight. So if push comes to shove Forza Italia and the League might be able to work it out with outside support from other MPs (on a case by case basis). Yet, even if the centre-right succeeds, the government is unlikely to be long lived.

Grand coalitions’ main players suffer large defeat

Moving on, underperformance by both the centre-left Democratic Party (PD) and the centre-right Forza Italia makes a grand coalition as projected prior to the elections close to impossible. A marriage of convenience between the Democrats and Forza Italia could work politically, but it does not work numerically. For the Chamber for example, they would need to lure the support of almost a hundred MPs of the League, Five Star (M5S) and Free and Equal: good luck with that! If they would succeed, we would rather call it a government of national unity. But for that to happen, all other options would need to be depleted first.

Populist government could work numerically, but not politically

The populist Five Star and the League have the numbers, but they would make for strange bedfellows. Keep in mind that the M5S base originates from the left, while the League is a far-right party. Also, until not so long ago Salvini of the League openly despised people from Southern Italy, indeed from the regions where the supporters of M5S reside. If they could make it happen it will likely break down within a year.

A government including Five Star and the Democratic Party would also have a majority and share some leftist ideas, but here the issue would be that Five Star is an anti-establishment party, while the PD is part of the establishment.

A final option might be the combination Five Star, Free and Equal and the left flank of the PD. Yet the numbers might not add up, and again (anti-)establishment issues are at play. Five Star is divided between pragmatists and conservatives on the issue of coalition building. Yet, also for the party joining a Five Star led government the downside of trying could be larger than of refraining. Still, there are rumours that rebellions within the PD would be inclined to support a Five Star government, either from within or from the opposition. The League’s leader Salvini already mentioned yesterday he will not form an alliance with Five Star. Still, given that the numbers do add up, we cannot completely ignore this risk.

President Mattarella faces tough task

Looking forward, everyone will look to Di Maio to make the first move, but it will be up to President Mattarella to hand out the mandates to govern. And Mattarella will likely take into account the prospect of governing, policy and financial market stability. If he believes that neither party could head a government that can guarantee such stability, we think that the president will eventually ask a respected figure, possibly current PM Gentiloni, to form a caretaker government until new elections are held. In that scenario, it could take more than a year before new elections are held. In any case, Italy seems to heading towards tough coalition talks, and the outcome is highly uncertain.

We believe the election outcome will have limited impact on the economy in the short term. Italy has entered a recovery phase amid a strong global economic environment and so far election uncertainty hasn’t bend producer and consumer sentiment. In our most recent publication on the economic outlook we explained that we expect the economy to grow by around 1.5% this year, like in 2017. We stick to our projections, but we acknowledge that the uncertain political outlook and the major victory for populist forces put downward pressure on our forecast. Policy uncertainty and possibly some increase in interest rates, could have a small dampening effect on spending decisions this year. In our view, the negative impact will be largest if a populist coalition between Five Star and the League would emerge.

Despite the fact that we think the negative impact on the economy is limited in the short run, the overall balance of risks is skewed to the downside. With public debt at 132% of GDP and a potential growth rate of around 0.5%, there’s no room for policy errors and complacency. Such moves would worsen the long-term economic and fiscal outlook, and could ultimately upset markets. Unfortunately, the reform outlook is weak and the risk of errors and accidents is quite large, especially if an entirely populist government emerges. Maybe counter intuitively, a caretaker government could be better for Italy than either a centre-right or populist government, as it would limit the risk of fiscal slippage. In any case, at best, some minor tweaks to simplify the tax system and lower the burden have some positive impact on economic growth, and fiscal slippage is being actively contained. At worst, fiscal prudence is thrown overboard and previous pension reforms are being rolled back, worsening debt sustainability and as such the economic growth outlook in the longer term.

If markets get upset and financial turmoil would increase it is very unlikely that an unexperienced populist coalition would be able to navigate the country out of a crisis. Yet also if a centre-right coalition government can ultimately secure a majority, stability is not guaranteed. While we expect that Forza Italia will not want to risk jeopardising the economic recovery, debt sustainability and financial market stability, the downward risk is that FI is being overshadowed by the more fanatical League. In that case, some structural damage might still be done. At this moment we don’t think debt sustainability will become an issue in the foreseeable future, but the large debt stock makes the country vulnerable to shocks.

Briefly turning to Europe, we believe the outcome complicates further Eurozone reforms. While Euro membership is not at risk, the next government will likely strike a more defiant tone towards Brussels and care less about European budget rules, worsening the relationship.

Market reaction so far has been relatively muted given the circumstances. The Italian spread over German bunds initially widened about 8bps, but already seemed to have reversed the post-election weakness on Tuesday. The Italian stock market is showing similar movements: a sell-off on Monday and a recovery on Tuesday.

Even though the strong performance on the part of the Five Star Movement and the League has resulted in a blow for the establishment parties and political gridlock, the market seems to have taken a relatively benign view. It suggests that investors weigh a negative ‘known unknown’ (i.e. the next government) against the arguably positive ‘known knowns’ of Italy’s positive cyclical performance and the limited immediate impact the elections will have on this performance.

While we think that debt sustainability is not at risk at the moment we feel that the market currently underestimates the potential economic and fiscal fallout in Italy in the longer term.