Italy's Populist Coalition Not as Populist as Feared

After weeks of negotiations and bizarre media leaks, Italy’s populist parties—the League and Five Star Movement (M5S) have an official deal. Sort of. Party leaders have agreed on a coalition plan, which they published for all to see, but rank-and-file party members could still upend it. Come Monday, Italy could have a government or fresh elections. But while uncertainty probably lingers as they deliberate and try to clear the final hurdles, a close look at the final plan shows Italy should avoid investors’ worst fear: a populist government dead-set on leaving the euro.

Despite that better-than-expected outcome, Italian stocks tumbled again Friday, and some parts of the plan have investors concerned. It contains an aggressive anti-immigration platform, including plans to deport nearly 500,000 recent immigrants. The budget also remains a source of worry, as it targets fiscal expansion that pushes up against the EU’s 3% deficit limit. Major provisions include a €780 monthly income for the poor—paid for by EU contributions to Italy’s budget—and a two-tier tax rate, with deductions. It also calls for the removal of EU sanctions against Russia and altering bank bailout rules to undo the late-2016 Monte Paschi bailout. Investors largely see all of these terms as confrontational with EU rules. At the same time, however, most of them were leaked in recent days and aren’t a big surprise, aside from the aggressive deportation plans.

At the same time, consider what isn’t in the plan. The provision in this week’s leaked draft calling for the ECB to forgive €250 billion in Italian debt was dropped. So was the call for a formal pathway to leave the euro. Additionally, there is no demand for a referendum on leaving the euro or EU. A populist-run government withdrawing Italy from the eurozone or EU was the biggest fear going into the election—now, markets can get over it. Dropping the debt clause is also a positive. Any time a government mentions messing with the sovereign debt market, even in a draft, it doesn’t instill bond market confidence. Silencing that talk, for now at least, should at least partially restore bond investors’ confidence.

While having policy plans is an important step, there is still a long way to go—and the potential for this to fall apart. Both parties will take the contract back to their respective constituents and vote on it over the weekend. If both approve, they will still need to choose a Prime Minister. Then President Sergio Mattarella with review the coalition terms to ensure they align with Italy’s constitution. If he believes the agenda is unconstitutional, he can ask them to change the terms or revoke the government before it even gets started—calling new elections (something nobody really wants). If he rubber stamps the terms, M5S and the League can begin forming a cabinet. Each cabinet member needs to be confirmed by 50.1% majority in both houses of Parliament.

Once a cabinet is in place, they can start executing on the coalition government plans—which won’t be easy. To change the Italian constitution, a two-thirds majority vote is necessary. But the combined M5S/League coalition has a slim 53% majority, and that assumes they all vote the same way. On the details of lawmaking, M5S and the League are ideological incompatible, so the 53% majority is a far cry from a locked-in majority on many issues—particularly economic ones.

Overall, this process is still going to take some time to sort out. With so much in the air, uncertainty likely lingers over Italian stocks for a while. If snap elections were to occur, political uncertainty would spike, as both M5S and League have jumped in the polls since March’s election—potentially enabling them to win a joint majority. The political establishment knows this and is likely to give this coalition a chance to govern (knowing how difficult passing meaningful legislation will be).

If this proposed government comes to fruition, the uncertainty fog could be a small headwind for Italian stocks as investors weigh the extent of confrontational populist rhetoric against the EU. The sentiment overhang could promote some short-term volatility. But this should fade as the months go by and investors gradually realize the “new age of Italian politics” proves to be the same old story of a deeply gridlocked system, no matter which parties are in charge. As it becomes increasingly apparent that this populist coalition faces the fate of nearly every Italian government in the past 50 years—unable to govern together and getting nothing done—sentiment should improve, helping Italian stocks realize the benefits of falling political uncertainty.