Economics Group Special Commentary Jay H. Bryson, Global Economist jay.bryson@wellsfargo.com (704) 410-3274 Heads Up: Italian Political Risk Looms Large Executive Summary The Italian parliament is currently debating legislation that could reform that country s electoral system. If the legislation passes parliament in coming weeks, Italians could be going to the polls this autumn for a general election. Current opinion polls show that the populist Five Star Movement (Movimento 5 Stelle, M5S) would do well in an election, perhaps winning enough seats to form the next government. Electoral success by the M5S could send shock waves through Italian financial markets, and yields on Italian government bonds likely would move higher, perhaps significantly. We are not saying that default and financial crisis in Italy is inevitable. Potential volatility in Italian financial markets, and more broadly in financial markets worldwide, in the weeks and months ahead depend upon a number of political developments in Italy that are difficult to forecast. However, readers should be aware that the relative calm that has prevailed in financial markets in recent months could potentially be threatened, at least for a period of time, if political risk in Italy were to come to the fore. Has The Populist Tide in Europe Been Stanched? Coming into 2017 there were a number of scheduled elections in Europe this year that analysts knew could potentially lead to financial market volatility. 1 Following on the heels of the Brexit referendum in the United Kingdom last June and the election of Donald Trump in November, there was a sense that populist forces may have been in the ascendency in many western countries. In the event, concerns about a populist takeover of Western European countries may have been overblown. The populist Party for Freedom (PVV) did not do as well in the Dutch elections on March 15 as some polls had indicated prior to the election. Consequently, the PVV likely will not be represented in the next government in the Netherlands. 2 In France, Emmanuel Macron handedly defeated Marine Le Pen in that country s presidential election on May 7. But Europe is not completely out of the populist woods yet. Germans go to the polls for a general election on September 24. A few months ago, Chancellor Angela Merkel was looking vulnerable. Not only did support for the Social Democratic Party (SPD) surge in the spring when Martin Schulz was named its new leader, but the populist Alternative für Deutschland (AfD) was garnering around 15 percent of voting intentions. However, Chancellor Merkel s stock appears to have risen over the past few weeks. Her Christian Democratic Party (CDU) has won a few regional elections, and support for the SPD and the AfD has slipped. If the election were held today, the AfD probably would win some seats in the Bundestag but it likely would have limited representation. Moreover, Angela Merkel probably would become the German chancellor for the fourth time. Concerns about a populist takeover of Western European countries may have been overblown. Germans go to the polls on September 24. 1 See Political Risks in the Eurozone in 2017 (February 15, 2017). All Wells Fargo reports mentioned herein are available upon request. 2 Negotiations among the political parties regarding the make-up of the new government are still ongoing. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.
WELLS FARGO SECURITIES Political risks appear to be rising in Italy. Spreads on Italian government bonds have started to widen. Although political risks in the Netherlands, France and Germany may have receded, they appear to be rising in Italy. The Italian parliament is currently debating legislation that would change the country s electoral system, and some political parties want to hold new elections this autumn. Although the decision to dissolve parliament and hold early elections ultimately rests with Italian President Mattarella, the probability that Italians will go to the polls this autumn is rising. 3 Most opinion polls show that the populist M5S would win a plurality of votes if the election were held today. Beppe Grillo, the former comedian who is the leader of the M5S, has in the past called for Italy to leave the euro area, although he has recently softened his rhetoric. Nevertheless, a victory by the M5S, should it occur, would send shock waves through Italian financial markets, if not financial markets more broadly. A victory by the M5S would be the Italian equivalent of Brexit or a Le Pen victory (had it occurred) in France. How Can Italy Lead to Contagion in Other Financial Markets? For Italy to become a potential issue for financial markets in the remainder of 2017, two conditions must be met. First, early elections must be held. Second, the M5S must do well enough in the elections that it either forms the next government or has significant representation in the government. But a bigger question remains. Exactly how do Italian politics matter for financial markets outside of Italy? Significant electoral success by the M5S and other Eurosceptic parties would raise the prospect of eventual Italian exit from the Eurozone, and financial markets already appear to be pricing in some risk of that happening. As shown in Figure 1, the yield on the 10-year government bond in Italy relative to its German counterpart has risen by roughly 100 bps since early 2016. Meanwhile, comparable spreads in France and Spain have been more or less unchanged on balance over that period. In other words, the spread widening that has occurred in Italy over the past year or so appears to represent Italian-specific risk. Figure 1 Ten-Year Government Bond Spreads Over Germany 650bps 550bps France: June 2 @ 43.5 bps Spain: June 2 @ 129.8 bps Italy: June 2 @ 198.7 bps 650bps 550bps 450bps 450bps 350bps 350bps 250bps 250bps 150bps 150bps 50bps 50bps -50bps 2005 2007 2009 2010 2012 2014 2016-50bps Source: Bloomberg LP and Wells Fargo Securities As we have discussed previously, the debt sustainability of a government depends on nominal GDP growth, borrowing costs and the primary budget balance (i.e., the government deficit or surplus less interest payments). 4 Strong growth in nominal GDP, low borrowing costs and primary budget surpluses tend to reduce a government s debt-to-gdp ratio over time, while weak GDP growth, high borrowing costs and primary deficits tend to push up the debt-to-gdp ratio. The good news is that the Italian government has run primary surpluses in the current decade (Figure 2) and borrowing costs have generally been low. Unfortunately, nominal GDP growth has been weak (Figure 2). Consequently, the debt-to-gdp ratio of the Italian government has 3 The Italian president can dissolve parliament and call a general election at any time, but the election must be held no later than May 20, 2018. 4 See How Sustainable Is European Sovereign Debt? (March 4, 2016). 2
WELLS FARGO SECURITIES, LLC stabilized over the past few years (Figure 3). However, it remains elevated at roughly 130 percent and has shown no signs yet of receding. A victory by the M5S in an election this autumn would raise concerns that Italy could eventually decide to leave the Eurozone and reinstate the Italian lira as the country s currency. Although depreciation of the lira against the euro would stimulate Italian exports, it would also make it harder for the Italian government to service its euro-denominated debt. As witnessed during previous episodes of the European sovereign debt crisis, yields on Italian government bonds shot higher when investors started to worry about long-run prospects for debt sustainability in Italy (Figure 1). As noted above, spreads on Italian government bonds over their German counterparts have already widened. An electoral victory by the M5S likely would push Italian bond yields even higher. Figure 2 Figure 3 8% 6% Italian Economic Indicators GDP: 2016 @ 1.6% (YoY Percent Change) Government Primary Net Lending as % of GDP: 2016 @ 1.4% 8% 6% 25 20 Italian Government Debt Projections As a Percent of GDP Borrowing Cost: 1.5% Borrowing Cost: 3. Borrowing Cost: 5. 25 20 4% 4% 15 15 2% 2% 10 10-2% -2% 5 5-4% -4% 2000 2002 2004 2006 2008 2010 2012 2014 2016 2000 2005 2010 2015 2020 2025 2030 2035 2040 Source: International Monetary Fund and Wells Fargo Securities Figure 3 shows some hypothetical projections of the government debt-to-gdp ratio in Italy. At present, the Italian government can borrow at roughly 1-½ percent per annum and its primary budget surplus is equivalent to 1.1 percent of GDP. The consensus forecasts that nominal GDP will grow 2-¼ percent per annum. Under the simplistic assumption that these variables remain unchanged between now and 2040, the debt-to-gdp ratio would decline from roughly 130 percent at present to less than 90 percent in 2040. However, if borrowing costs rise to 3 percent, which was normal only a few years ago, then the debt-to-gdp ratio will remain essentially unchanged at roughly 130 percent over the next 20 years (under the assumptions that the primary budget surplus remains unchanged at 1.1 percent of GDP and nominal GDP continues to grow at 2-¼ percent per annum). If borrowing costs rise to 5 percent, which were reached during bouts of the sovereign debt crisis a few years ago, then the debt-to-gdp ratio would swell to more than 200 percent by 2040. Long-term debt projections are fraught with potential errors due to uncertainties surrounding growth, budget balances and borrowing costs. The point, however, is that a downward trend in the debt-to-gdp ratio of the Italian government is not necessarily assured. One does not need to resort to extreme assumptions to project a rise in the ratio in coming years. The outstanding debt of the Italian government totals about 2.3 trillion (approximately $2.6 trillion) at present, of which roughly one-third is held by foreigners. Default by the Italian government would probably lead to the collapse of the Italian financial system and could result in meaningful losses for some foreign financial institutions. The world may be able to absorb a default by Greece, but default and financial crisis in Italy, which is among the largest ten economies in the world, would be an entirely different story. A downward trend in the debt-to-gdp ratio of the Italian government is not necessarily assured. 3
WELLS FARGO SECURITIES Conclusion In our view, market participants should key an eye on political developments in Italy in coming months. If the Italian parliament approves legislation in coming weeks that would usher in a new voting system, then Italians could be heading to the polls this autumn for a general election. Recent opinion polls suggest that the populist M5S would do well in a near-term election, perhaps winning enough seats to form the next government. Electoral success by the M5S could send shock waves through Italian financial markets, and yields on Italian government bonds likely would move higher, perhaps significantly. Volatility likely would spill over to financial markets in other economies if investors started to fret about prospects for long-term debt sustainability in Italy. We are not saying that default and financial crisis in Italy is inevitable. Potential volatility in Italian financial markets, and more broadly in financial markets worldwide, in the weeks and months ahead depend upon a number of political developments in Italy that are difficult to forecast. Even if Eurosceptic parties such as the M5S come to power in Italy, there is no guarantee that Italy will leave the Eurozone in the foreseeable future. Our sole purpose in writing this report is to warn readers that the relative calm that has prevailed in financial markets in recent months could potentially be threatened, at least for a period of time, if political risk in Italy were to come to the fore. 4
Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) 410-1801 (212) 214-5070 diane.schumaker@wellsfargo.com John E. Silvia, Ph.D. Chief Economist (704) 410-3275 john.silvia@wellsfargo.com Mark Vitner Senior Economist (704) 410-3277 mark.vitner@wellsfargo.com Jay H. Bryson, Ph.D. Global Economist (704) 410-3274 jay.bryson@wellsfargo.com Sam Bullard Senior Economist (704) 410-3280 sam.bullard@wellsfargo.com Nick Bennenbroek Currency Strategist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com Anika R. Khan Senior Economist (212) 214-8543 anika.khan@wellsfargo.com Eugenio J. Alemán, Ph.D. Senior Economist (704) 410-3273 eugenio.j.aleman@wellsfargo.com Azhar Iqbal Econometrician (704) 410-3270 azhar.iqbal@wellsfargo.com Tim Quinlan Senior Economist (704) 410-3283 tim.quinlan@wellsfargo.com Eric Viloria, CFA Currency Strategist (212) 214-5637 eric.viloria@wellsfargo.com Sarah House Economist (704) 410-3282 sarah.house@wellsfargo.com Michael A. Brown Economist (704) 410-3278 michael.a.brown@wellsfargo.com Jamie Feik Economist (704) 410-3291 jamie.feik@wellsfargo.com Erik Nelson Currency Strategist (212) 214-5652 erik.f.nelson@wellsfargo.com Misa Batcheller Economic Analyst (704) 410-3060 misa.n.batcheller@wellsfargo.com Michael Pugliese Economic Analyst (704) 410-3156 michael.d.pugliese@wellsfargo.com Julianne Causey Economic Analyst (704) 410-3281 julianne.causey@wellsfargo.com E. Harry Pershing Economic Analyst (704) 410-3034 edward.h.pershing@wellsfargo.com Hank Carmichael Economic Analyst (704) 410-3059 john.h.carmichael@wellsfargo.com Donna LaFleur Executive Assistant (704) 410-3279 donna.lafleur@wellsfargo.com Dawne Howes Administrative Assistant (704) 410-3272 dawne.howes@wellsfargo.com Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2017 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE