RaboResearch - Economic Research

Italy: Elections amid a cost of living crisis

Economic Update

  • In the second quarter, Italy’s GDP growth of 1% q/q pushed GDP above its pre-pandemic level
  • The labour market continues to go strong, with the employment rate at a record-high
  • Yet the economic trend is weakening and the outlook bleak
  • The cost of living crisis significantly hurts households purchasing power, while cost pressures hamper production
  • We expect Italy’s economy to enter a recession end this or early next year
  • The depth of the recession substantially depends on whether Italy will face actual gas shortages
  • The outcome of September’s election is uncertain, though the most likely outcome is a right-wing government headed by the radical right
  • Such a government would likely lead to more conservative and nationalist social policy, delays in the implementation of the EU recovery plan and more friction with the EU
  • Yet euro membership is not at stake and a complete abandoning of the recovery plan is unlikely

GDP has recouped pandemic losses

In the second quarter, Italy’s GDP growth of 1% q/q substantially beat consensus and pushed GDP above its pre-pandemic level (Figure 1). A breakdown into components isn’t available yet, but the statistics office stated that domestic demand was the driver, while net foreign demand made a negative contribution. This boost from domestic demand at least partly stems from the reopening of the economy. Meanwhile, the labour market has also continued to improve, with the unemployment rate (8.1%) some 1.5 percentage points below pre-pandemic levels and a record-high employment rate of 60.1%.

Figure 1: GDP above pre-pandemic level
Figure 1: GDP above pre-pandemic levelSource: RaboResearch, Eurostat, 2019
Figure 2: High inflation will hurt consumption
Figure 2: High inflation will hurt consumption Source: Macrobond, RaboResearch

Cost pressures are a severe headwind

Although the Q2 growth data is certainly good news and will automatically lift this GDP growth for the year as a whole, the trend is weakening and we remain of the view that the outlook is bleak. We expect Italy to enter a recession end this year or early 2023 as the boost of reopening fades. While the Italian economy might still benefit from a very good tourism season ove the summer, higher interest rates and especially the cost of living crisis will start to bite. In July, overall inflation dropped 0.1pp from its record-high in June to 8.4% (HICP), while the price index of frequently bought products (including food) reached its highest level on record (9.1%). At least partly because of the high inflation, consumer sentiment reached its lowest level in July since the sovereign debt crisis in 2011/2012 (Figure 3). Both inflation and a fall in sentiment will lead to lower household spending. Finally, while deadlines to complete projects eligible for the ‘superbonus’ for home renovations that has been in place since 2020 have been extended time and again, the outgoing government has so far refused to extend the scheme beyond 2022. Unless the next government decides otherwise, the end of the scheme will likely have a substantial impact on housing investment.

Figure 3: Consumer have turned very pessimistic, while sentiment among businesses is weakening
Figure 3: Consumer have turned very pessimistic, while sentiment among businesses is weakeningSource: Macrobond, Eurostat
Figure 4: Manufacturing activity contracted in July
Figure 4: Manufacturing activity contracted in JulySource: Macrobond, Eurostat, IHS Markit

Besides households, businesses are also struggling with cost pressures. Production of energy-intensive goods has already been pared back since gas prices started to spiral upwards over the second half of last year. But that has now come to a point where broader manufacturing production has started to suffer. Together with a sharp contraction in order books, cost pressures caused manufacturing factory output to decline in July at its fastest pace since April 2020, according to the PMI survey. The overall PMI stood at 48.5, indicating manufacturing activity shrank in July.

To soften the blow of increased food and energy prices for households and businesses the government has recently approved another support package, worth EUR 26bn. This comes on top of already introduced measures worth about EUR 28.5bn. Hence, total agreed support amounts to some 3% of GDP. Yet, while it is necessary to support vulnerable households and prevent food and energy insecurity, the government is limited in its ability to support the entire economy, as too much support would lead to further price pressures as demand is kept intact.  

All in all, we forecast the Italian economy to grow by 3.3% this year and to contract by -0.6% next year. The main risk to our outlook is a complete stop in Russian gas flows. High energy prices for longer are already part of our baseline projections, but shortages are not. Despite the measures Italy has already taken, it would probably still face gas shortages this winter if Russia were to stop sending gas entirely, pushing growth further into contractionary territory.

What next in Italian politics

In these already turbulent times, Italy will head to the ballot box on 25 September. The Draghi-government will remain in office until a new government is formed. But implementation of the reform milestones set out in Italy’s recovery plan will likely be delayed until the next government is installed. That puts the December tranche worth EUR 19bn (1% of GDP) at risk.

What the next government will look like is not set in stone. The centre-left Partito Democratico (PD) and the radical-right Fratelli d’Italia (FdI) are neck and neck in the polls, receiving 23% and 24% of votes respectively. Still, elections are most likely to result in a right-wing coalition led by FdI’s Georgia Meloni: Italy’s election law benefits pre-election coalitions and right-wing parties –including centre-right FI and far-right Lega– are likely to run together, while the left is much more splintered. An FdI-led government would mark a clear shift to the political right, which in any case would mean more resistance against immigration, abortion, and same-sex marriages to name a few. At the same time, euro membership would not be at stake and Meloni has been a strong advocate of supporting Ukraine. This suggests Italy will continue to stand united with the EU. As time progresses and the economic outlook worsens, there is a risk, however, that Salvini’s Lega intensifies its call for peace talks rather than sending weapons to Ukraine and sanctioning Russia.

Finally, it remains to be seen what this would mean for economic policy as no official party programmes have been published yet. It is known that the right is in favour of tax cuts, while for example judicial reforms required for EU recovery money have not gone down well across the board. Moreover, given FdI’s opposition against parts of Draghi’s recovery plan, they are likely to try and alter part of the investment destinations and reform milestones agreed with Brussels. The EU has already said there is not much wiggle room to change the plan. The above suggests that friction between the EU and Italy will probably increase if the elections result in a Meloni-led government. This which would probably push government bond yields higher - For our in-depth study on the impact of rising yields for Italy’s public finances click here.

That said, the government cannot afford to lose the EU funds and is expected to eventually fall in line, though possibly only after sufficient turbulence. Moreover, over the past weeks, Meloni and her allies are trying hard to build credentials, with officials close to her saying that she would respect EU budget rules. Clearly, that will not be difficult in 2023, with the rules still paused, but thereafter it’s a whole different story.

Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO

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