The announcement that Italy has formed a government initially sent a wave of relief over markets, most probably because this has distanced the spectre of fresh elections that could have turned into a referendum on exiting the single currency.

This relief is also tied to the view that Italy’s long-standing political processes will hamper the League– Five Star Movement coalition government’s attempts to implement its pledges and that it will be all talk and no action.

We believe that caution is the watchword. Italy’s politics remain unstable and the possibility of fresh elections in the short term will influence how the new government acts. Exiting the single currency is currently a side issue, as we believe the main risk is Italy’s finances. A nation carrying a debt-to-GDP ratio in excess of 130% and that has very low levels of potential growth has little fiscal headroom. Even if the government’s programme was only partially implemented, the resultant strain on its finances would undermine debt sustainability and produce a head-on collision with the eurozone budget framework.

I.           A politically volatile situation

The results of Italy’s general election on 4 March reflect a more widespread shift that is challenging many traditional political parties in western nations. A decade ago, the Five Star Movement did not even exist, and the League was campaigning for the independence of the Po Valley region in northern Italy. The two parties have many differences but share common ground in that they are both antiestablishment.

The Five Star Movement was founded in 2009 by Gianroberto Casaleggio and Beppe Grillo. While Beppe Grillo was the public face of the party, Gianroberto Casaleggio was the party’s linchpin and replaced by his son in 2016. Davide Casaleggio administrates the platform that forms the kernel of the party, hosting information blogs and online voting sites. The Casaleggio family is seen as the movement’s kingmakers and suspicions hang over links between the family’s IT consulting company and the party. Initially conceived as an expression of anti-establishment discontent, the Five Star Movement is based on quite a radical notion of direct democracy. The movement lacks any ideological foundation. It is in effect a vessel that holds members’ opinions and acts as an echo chamber for them and for the most popular measures. This has resulted in a combination of an extremely tough stance on immigration and environmental and socially responsible measures. In preparation for the recent elections, party militants directly voted for both the election candidates and the party’s campaign measures. When Luigi di Maio did his best to distance himself from some of the party’s previously adopted positions, such as exiting NATO and the eurozone, the Deputy Prime Minister found himself roundly criticised by the movement’s more hostile fringes. The question is, how secure is his position as leader of a movement originally intended – to have no leader.

Matteo Salvini, leader of the League, is a different story. A long-standing militant, Matteo Salvini rose to power after the 2013 election debacle when the League was still the Northern League. Matteo Salvini has transformed the party, shifting its focus towards immigration issues and opposing a Brussels-based Europe. During the recent elections, the party aligned itself with the right-wing Forza Italia and Fratelli d’Italia parties. The League, which was initially a junior coalition partner, actually won more votes than Forza Italia and, as shown in the graph below, since 4 March its popularity has been rising significantly faster than that of the three other main parties. This gave the League a bigger voice at the government negotiation table than its 17% election result would have normally allowed. Two government ministers currently in the news are sympathetic to the League, namely Paolo Savona, who was initially pencilled in for the Finance Ministry but finally went to European Affairs, and Giovanni Tria, who is now Finance Minister.

The government is officially led by Giuseppe Conte, but the real political heavyweights are the two Deputy Prime Ministers, Luigi Di Maio (Minister for the Economy) and Matteo Salvini (Interior Minister). Each party speaks to a very different public and it will doubtless be difficult to keep them on an even keel. As such, the notion of fresh elections is likely to linger. Both parties will doubtless be seeking to deliver on their election pledges so that they can be assured of a win if early elections are indeed called. Giuseppe Conte’s inaugural speech demonstrated a willingness to make fast progress.

This government’s survival will depend largely on the balance of power between the two parties and on their respective political positioning, especially that of Matteo Salvani. Coalition polls suggest that a right-wing alliance could be nearing the threshold required for an absolute majority in both houses of parliament.

II.         Exiting the eurozone: currently a side issue

Neither the League nor the Five Star Movement mentioned exiting the eurozone during their election campaigns for 4 March. Indeed, Giuseppe Conte emphasised that ‘Europe is our home’ and that his government had no intention of exiting the eurozone. Survey results show that a majority of Italians currently wish to retain the single currency despite the fact that among European populations, the Italians hold the most negative opinion of the euro.

Does this mean that the single currency exit plan referred to in the first draft of the coalition agreement has been abandoned? A faction of the Five Star Movement still supports the idea and the League voters are also in favour of Italy exiting the eurozone. So even if the country’s leaders are currently excluding this option, there is nothing to guarantee that the idea has gone forever. Matteo Salvani’s recommendation in 2016 to remain silent on the subject during the election campaign in order to better implement the strategy once in power leaves a question mark hanging over the whole issue.

If it does come back to the fore, the institutional procedure for securing an exit is relatively long. Article 75 of the constitution prohibits holding a referendum on international treaties, including the treaty that instigates the euro as the country’s currency unit. A two-thirds majority in both houses is needed to alter the constitution and this threshold level is currently out of the coalition’s reach. Two other solutions exist if the government is determined to pursue an exit: either it could hold another election and hope to win two-thirds of the seats in both chambers, or it could first vote to modify Article 75 of the constitution and then proceed to Article 138. A reform of the constitution first requires a vote in both houses after two debates held at a three-month interval and then ratification via a referendum. Once modified, Article 75 would allow for a referendum on the euro.

The scenario of a masked single currency exit is not impossible either. The ‘contract for the government of change’ takes up the idea of issuing ‘Mini-BoTs’, or small denomination, non-interest-bearing treasury bonds, which could be used to pay government suppliers and other creditors. These securities could then be resold and used to pay taxes. Several analysts see this as effectively issuing a parallel currency as a precursor to a new lira.

Even if these various scenarios are not yet on the table, they could spook the markets, depending on the governing coalitions’ budget decisions.

III.        The real issue: fiscal policy

Various sources are putting the cost of the new measures at over €100 billion, or between 6% and 7% of GDP. Although it would take time to implement the full package of measures, Italy’s finances are not robust enough to withstand any great degree of fiscal easing. As shown in the graph below, the economic expansion that started in 2014 has merely allowed the debt-to-GDP ratio to stabilise.

Almost €50 billion of the €100 billion price tag (2.8% GDP) is due to the government’s flat tax proposal of two flat rates, 15% and 20%, that would apply to households and companies. This tax measure is expected to come into force in 2019. Its cost would be lower if some tax loopholes were closed. Some IMF studies have estimated that loopholes amounting to €19 billion could have been closed without significantly impacting growth, yet the authorities have never acted to do so. Will this new government be any different?

The government has pledged to introduce a supplemental income, a variation on the notion of universal basic income. Its payment would depend on an individual’s resources and is designed to push monthly income per single person up to €780. Beneficiaries also have to actively seek employment and income payments will be revoked if they refuse a set number of job offers. In principle, this reform will only start to impact the State’s finances in 2020, after the job centres receive an additional €2 billion in 2019 as part of the active employment policy.

In addition, the government is seeking to row back on some of the 2011 pension reforms. What exactly would be changed is currently unknown, hence cost estimates ranging from 0.8–1.6% of GDP. It would appear that the government is seeking to scrap the recently extended pension age and open up more opportunities to take early retirement.

Previous governments included a contingency clause whereby VAT would automatically increase in the absence of spending cuts. If the 2019 budget does not include some €12.5 billion in cuts, VAT will rise by two percentage points on 1 January. The government will most probably look to remove this measure.

Other measures, especially concerning families, can also be expected. Aside from the suitability or otherwise of the new government’s promises, Italy’s problem remains the fact that just a small rise in the deficit, especially given the recent rise in funding costs, would set the debt-to-GDP ratio on an uptrend.

Interest rate risk is limited. Italy’s Treasury has taken advantage of favourable financing conditions to extend its debt maturity profile and it only has to roll over 12% of its total stock of debt in 2019, 10% in 2020, and 9% in 2021. Higher interest rates will therefore only gradually filter through and are not a direct threat to the direction of the debt-to-GDP ratio. In addition, and as can be seen in the graph below, current interest rate levels are still below the average coupon rate on bonds due for rollover in the years ahead and this will enable average funding costs to continue to fall, providing that market rates remain stable.

The trend for Italy’s debt-to-GDP ratio mainly depends on changes in the fiscal balance. As the graph below shows, if the recent spate of spread widening lasts, the deficit only needs to deteriorate by a 0.5% of GDP for the ratio to rise.

These scenarios are based on a growth trend and do not take into account the secondary effect on growth of higher financing costs. The reality is that, based on the economic cycle, we can expect a fresh recession within a decade, which would negatively impact the dynamics.

Even just implementing a small part of the government’s agenda could raise real questions in terms of Italy’s debt sustainability. With this in mind, spread tightening would appear unlikely. So, is a crisis unavoidable? Certain factors suggest that a repeat of 2011–2012 is unlikely. Firstly, Italy is running a current account surplus of about 3.0%, whereas in 2011 it was carrying a 3.0% current account deficit. Secondly, as shown in the graph below, non-residents are holding considerably less debt than previously, although the amounts remain significant.

Several issues need to be monitored in the next few months. The reaction from the credit rating agencies will be an important factor. Italy is currently ranked BBB or the equivalent by the three main credit rating agencies, and DBRS rates it one notch higher. Several years ago, the ratings agencies set a fixed schedule for announcing their ratings, barring exceptions. Moody’s has already placed Italy on negative watch and will make a firm announcement on 7 September. In the meantime, DBRS will publish its rating on 13 July and Fitch on 31 August. S&P, which inched Italy’s rating up in October 2017, will publish its update on 26 October. The credit rating agencies are undoubtedly awaiting more material information before making any changes, but the 2019 budget approval procedure is not expected to start until mid-September. The next few months will most likely see Italy placed on negative watch rather than actually undergoing any official downgrade. However, this means that the country will probably then be downgraded in the first half of 2019.

The market has partially priced in such a scenario. Current sovereign spreads are now in line with a BB rating. However, if Italy’s average rating deteriorates below investment grade, there will be consequences for the investors who can only hold investment grade assets.

This may also then have an impact on the ECB’s purchasing programme, because it can only buy high quality assets: the credit rating constraint is only avoidable if a country is receiving support via the European Stability Mechanism.

Italy’s budget decisions may also lead to tension with its European neighbours. With a 2.3% budget deficit in 2017, Italy is no longer subject to the excessive deficit procedure but its extremely high debt level requires appropriate debt reduction measures and its medium-term objective entails reducing the structural balance by 0.6% in 2018. Any deterioration in Italy’s financial situation could mean a return to the excessive deficit procedure along with the potential of financial sanctions.

IV.       Impact on banking securities

Italy’s election outcome has significantly impacted our investment scenario and outlook for Italian banking names.

The series of measures announced by the new coalition demonstrates its lack of understanding of how the banking system operates and the uphill struggle still facing Italy’s banks.

As things stand, the coalition is proposing to:

• revise the Monte dei Paschi bailout plan with little explanation of what is wrong with it;
• implement a ring-fencing system to separate retail from investment banking activities, which is a long, costly, and arduous process;

• arrange a ‘bail-in’ via improved damages compensation for Italian savers without knowing who will foot the bill;
• toughen recovery conditions for bad debt, which could reduce foreign investor demand and slow down the ongoing clean-up of banks’ balance sheets despite non-performing loans still being a significant problem, and despite the efforts made so far;
• let GACS expire (government guarantee scheme to ease bad debt securitisation);
• revise the Basel banking rules, a sketchy plan which would cause another clash with the EU;
• apply a flat tax that would significantly reduce the value of huge volumes of Italian banks’ deferred tax assets.

a) Solvency impact

The coalition’s agenda, as it stands, can be expected to reduce Italian bank solvency :

• via eroded equity capital given wider Italian sovereign spreads that will devalue their bond portfolios as well as their own regulatory capital provisions ; also via the eurozone exit scenario and the risk that such an exit starts to take hold as the ECB’s quantitative easing programme comes to a close.
• and via reduced capacity for Italian banks to issue much-needed eligible debt (MREL/ TLAC).

Italian banks are not the only ones to be affected by the coalition’s agenda. European bank exposure to Italian sovereign debt is sizeable: €292 billion according to the latest data from the European Banking Authority.

b) Profitability impact

The coalition’s agenda is also likely to translate into lower profitability via:

• more expensive funding costs for Italian banks;
• higher costs for Italian bank balance sheet clean-ups;
• a deviation in the country’s economic upturn through a fall in both investment spending and credit expansion.

More broadly, some European banks, and especially French banks, have significant business activities in Italy.

c) Purely financial impact

Italian debt ratings risk being downgraded because the agenda outlined so far is light on detail and the outlook for public finances is worsening. Moody’s believes that Italy’s current rating is inconsistent with the negative direction the budget is taking.

Current uncertainty is putting a strain on long and short-end Italian rates, resulting in a flatter yield curve.

Senior European bond spread widening has so far been moderate at +20 bps overall, unchanged in certain areas (UK, Nordic region, France), and +20 bps in Spain. But Italian banks are the hardest hit: +70–120 bps.

Cost of capital for the sector now exceeds 10%. Bank stocks are trading at a 30% discount compared with the market, versus an average discount of 18% over the past decade. The risk premium attached to all European banking names has risen.

The European banking sector fell almost 15% in May (9% excluding Italian banks). The fall has been broad-based but accentuated by Italian banks (20%).

d) Our analysis

Without greater clarification, the uncertainty surrounding Italian politics could underpin or even exacerbate the European market’s risk premium and volatility for as long as the crisis lasts. Bank valuations will be affected worst. The election has resulted in the formation of a majority government that appears well rooted and we believe that the crisis could indeed last. While the examples of Spain, Greece, and to a lesser extent, France show just how pragmatism can prevail, the UK example, with Brexit, illustrates the opposite.

There is a rising probability of a scenario whereby rate rises could be delayed, lowering expectations of a recovery in European banks’ interest margins at a time when their cost of capital is rising. Earnings

expectations could fall by as much as 10%. More specifically for Italian banks, a slowdown in economic growth (investment and credit) together with a rise in credit defaults is possible.

European bank holdings of sovereign debt would clearly be a legitimate concern if Italy were to quit the eurozone. The amounts held by the European banking system (€292 billion) represent 23% of European banks’ core equity capital. A significant percentage. However, if we exclude Italian banks’ volumes, this exposure drops by almost half to €149 billion, or 13% of European banks’ equity capital. The market will be carefully watching both how Italian bank deposits develop during the months ahead and the likelihood of any bank run.The stress on Italian sovereign debt (BTP-buoni del tesoro poliennali) is affecting the whole of the European banking system. However, the effects will more severely impact southern European banks, which are most affected by low rates and most exposed to Italian TLTRO/BTP carry trades set up to compensate significant pressure on interest rate margins. Equally, their interest rate margins will be hardest hit by shifting interest rate expectations and will suffer the greatest deterioration in solvency levels.

However, in the short term, the market will be bemused by the absence of any significant impact of the crisis on European banks’ earnings and equity capital. Indeed, a large proportion of sovereign bonds are valued at historical cost. The European banking system’s dependence on funding from the market is now more modest after years of deleveraging and refinancing in tough market conditions will only be very gradual. For instance, Banca Intesa’s market-based funding needs between now and 2020 are €26 billion. When a credit spread of 200 bps is applied, the cost of this scenario comes in at €0.4 billion, or 7% of expected 2020 earnings.

As ever, financial analysis is key. Even though both BNP and Crédit Agricole are present in Italy via BNL and Cariparma respectively, these Italian entities only represent 10% and 13% of their pre-tax and pre-provision earnings.

Conclusion: how serious is the contagion threat?

The markets are likely to remain on a knife edge over Italy for some time. If the government delivers on its series of measures, spreads could widen further, and the European Commission’s stance could toughen. How would the Italian government react? Can we ignore the scenario of the League looking to generate conflict with the European Commission and the other key EU members so as to mobilise Italy’s citizens and ultimately lead the country out of the eurozone? The next European summit meeting on 28–29 June will address completing the Banking Union and will doubtless be an opportunity to observe what type of relationship the new government is seeking to establish with the rest of Europe.

None of these issues should detract attention from the country’s fundamental problem of low potential growth. With almost non-existent productivity growth in the past 15 years and an active labour force expected to shrink, the country desperately needs a set of structural reforms that do not feature on the government’s agenda.

That said, we see contagion as less of a threat now than previously. Global growth remains robust, driven especially by the US, but also by the eurozone where, despite recent falls, the PMI indices remain consistent with growth of 2%. Spain and Portugal’s relatively moderate spread widening demonstrates that investors are now viewing these countries separately. Europe’s banking system is far more robust than it was during the eurozone crisis, and the ECB has also expanded its toolbox. If the contagion threat rises, the ECB could activate the Outright Monetary Transactions (OMT) programme to support Spain and/or Portugal. Given their already significant efforts, any conditions could be relaxed.

Against this backdrop, risk premia on Italian assets could remain relatively high. Recent events will be unlikely to deter the ECB from its decision to bring its asset purchase programme to a close by the end of 2018 and the bank is similarly unlikely to change its growth scenario for the months ahead. However, given the factors discussed above, we can neither ignore the possibility that the crisis could deteriorate, nor the uncertainty reigning over how the Italian authorities might react. Faced with a sharp deterioration in the country’s funding conditions, will the authorities return to a more orthodox policy, or forge ahead regardless?

Julien-Pierre Nouen, CFA

Chief Economist and Head of Multi-Asset Investment

Scander Bentchikou

Fund manager/Analyst, European and Eurozone Equity

Banks, insurance companies, real estate and IT sectors

The opinion expressed above is dated June 2018 and is liable to change.

This document is not pre-contractual or contractual in nature. It is provided for information purposes. The analyses and descriptions contained in this document shall not be interpreted as being advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.