Italy: elections unlikely to hamper economic recovery
- Italy’s economy had a relatively strong year in 2017 and the short-term economic outlook is quite rosy
- The next government is unlikely to hamper the current economic recovery
- We deem it unlikely that a populist government will emerge after Sunday’s elections, but that does not mean the elections carry no risks
- In fact, the balance of risks is skewed to the downside. With public debt at 132% of GDP and a weak potential growth rate of below 1.0%, there’s no room for policy errors and complacency
- Unfortunately, firm (fiscal) policy cannot be expected and the risk of policy errors and accidents is quite large
- The market may currently be too complacent about risks related to the elections, focusing only on the limited probability of a Five Star government. If anything else than a Grand Coalition emerges, we may see some repricing of risk assets
Economic outlook quite rosy in the short term
Italy’s economy had a relatively strong year in 2017. The economy grew with 1.5% after 1.1% growth in 2016. While the growth rate isn’t impressive in international comparison, it was the fastest growth rate since 2010. The breakdown of the fourth quarter isn’t known yet, but in the first three quarters of 2017 domestic demand was the main growth driver (figure 1), whilst the net contribution of foreign demand was about zero. That said, the acceleration in the headline growth figure compared to 2016 was mainly the result of the contribution of net trade turning slightly positive in 2017. The contribution of domestic demand was more or less stable compared to 2016. Looking forward, the short-term outlook is quite rosy.
Both producers and consumers are very optimistic and the manufacturing PMI is even close to a record high (figure 2). Italians do not seem to worry about the upcoming elections. We believe growth will remain stable at around 1.5% this year and slightly decelerate to 1.2% in 2019. In both these years, the main contribution to growth will stem from a cyclical recovery in domestic demand. Buoyant sentiment and employment growth (figure 3) underpin consumption spending and residential investment. The upward potential for household spending is however limited due to negative or muted real wage growth, the large share of hiring on temporary contracts and household saving rates close to historic lows. Business investment is likely to get a boost from positive sentiment, increasing capacity utilisation rates, improved profitability and balance sheets, strong order books (figure 4) and tax incentives incorporated in the budget 2018. But the outlook for construction investment remains weak.
For the longer run, our growth forecast is less benign. After the cyclical recovery in the next two years, we forecast growth to fall back to its potential of between 0.5% and 1.0%.
Elections unlikely to hamper economic recovery
If the upcoming elections of 4 March play out as we expect, the outcome will have limited effect on Italy’s economic outlook. The reform agenda remains weak because the next government will have a weak majority at best and/or be an uneasy coalition. Also, the weak state of government finances limits the government’s room to support the economy. Still, depending on the coalition that emerges, some tax incentives to improve the functioning of the labour market and/ or some minor tweaks to simplify the tax system and lower the burden are possible. This could have some positive impact on economic growth. And while some fiscal slippage could occur, debt sustainability is unlikely to be put at risk, at least in the foreseeable future. On the downside, a fragile parliamentary majority, no majority at all, and even a centre-right coalition government, could lead to policy uncertainty and some increase in interest rates, which could have a small dampening effect on economic activity this year. Moreover, if some parties’ proposals to increase pensions and roll back previous pension reforms make it to the table, these measures could worsen debt sustainability and as such the economic growth outlook in the longer term.
Italian elections: three scenario’s, downside risks
We expect the upcoming elections to yield a very fragmented parliament (for a more detailed description of view on the elections and their implications please see our recent Special). The centre-right has the best chance to form the next government (figure 5). But the less leverage the moderate Forza Italia will have over the radical (Northern) League, the lower the probability of success. If the centre-right fails or the centre-left Democratic Party unexpectedly comes out strong, a Grand Coalition including the Democratic Party, Forza Italia and other centrist parties will get more likely. If that fails as well, President Mattarella will likely ask current PM Gentiloni to head a caretaker government and to navigate Italy towards fresh elections. While the numbers might add up, we deem a populist coalition government with Five Star, the (Northern) league and the Brothers of Italy, or a coalition between Five Star and the ‘establishment’, very unlikely.
Still, the balance of risks is skewed to the downside. With public debt at 132% of GDP and a potential growth rate of below 1.0%, 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, firm (fiscal) policy cannot be expected and the risk of policy errors and accidents is quite large. If a centre-right coalition emerges, this would especially be the case if the (Northern) League has posted strong election results.
The market may currently be too complacent about risks related to the elections (figure 6), focussing only on the limited probability of a Five Star government. If a Grand Coalition emerges, limited market moves should be expected as this would roughly imply policy continuation. If not, we may see a repricing of risk assets. Turbulence would be largest if an entirely populist government emerges.