Italy’s President Weighs His Options, and None of Them Look Great

(Bloomberg) -- All eyes are on the president now.

After Italy’s coalition government collapsed on Tuesday, 78-year-old head of state Sergio Mattarella is embarking on a crucial round of consultations with political leaders to see if he can carve out a new majority.

Italy’s President Weighs His Options, and None of Them Look Great

Italian presidents spend much of their time greeting obscure world figures, attending gala luncheons at the lavish Quirinale palace and promoting the country’s history and culture.

But then there are moments like this: the economy is on the brink of recession, there’s a budget to be drafted which must adhere to stringent European Union deficit rules, and no one is in charge of the government. Only the president has the power to nominate a new leader.

If he can find a combination that can command a majority, if only for a few months, he’ll be able to bring a measure of stability to his troubled country. If he fails, Italy will be lurching toward new elections at the worst possible moment -- and Matteo Salvini, the hardliner who triggered the crisis, will be in pole position to take charge.

Here are the president’s options:

1. The Democrats and Five Star form a government

The center-left Democratic Party, or PD, and Luigi Di Maio’s Five Star Movement have long been at each others’ throats. Now, they’re weighing a possible alliance to forestall new elections and block Salvini’s grab for power.

Pros:

  • The linkup would be a body blow for Salvini, who’s seen as an opportunist pursuing his personal ambition by many in the Italian establishment.
  • Lawmakers from both parties would be kept in line by the prospect of holding on to their parliamentary privileges -- Five Star’s polling numbers suggest half of its deputies would be in search of new work after an election.

Cons:

  • Although there is some common ground on environmental and social issues, the parties are far apart in most areas and have been fighting for years.

What Mattarella might think:

  • The president’s main concern is providing stability for the economy; a new coalition is his best chance of staving off an election. The question is, would it hold?
  • Daily Corriere della Sera reports that Mattarella is willing to extend the talks to allow the two parties to iron out the kinks.

What the markets say:

  • “Even if a PD-Five Star government looks unsustainable, it will delay an election at least for a while,” says Arne Lohmann Rasmussen, head of fixed-income research at Danske Bank AS. “The rally we have seen could have further to go.” Italy-Germany 10-year yield spread would narrow to 185 basis points, according to the bank.
  • Investors will rejoice and Italian stocks will have a relief rally as it averts the risk of a Salvini government, according to Manish Singh of Crossbridge Capital.
  • A “strange compromise,” says Chris Bailey, a European strategist at Raymond James Financial International, but “essentially pro-European and everyone will be hopeful of a much quieter life,” resulting in a relief bounce for stocks.

2. Technical government

  • Mattarella could opt for the creation of a non-political government with a limited mandate to approve the 2020 budget law and avoid a VAT hike, which is otherwise baked in. Italy would then go back to the polls at the beginning of the new year.

Pros:

  • This could win broad support, from Five Star and the PD first, but also possibly Silvio Berlusconi’s Forza Italia, which has said it is not seeking to form an alliance with Salvini.

Cons:

  • Populists are still making political capital out of the austerity imposed by the last technocratic government during the euro crisis.
  • This one would be a short-lived government, fuel Salvini’s attacks on the establishment, and leave the country back where it is now a few months down the line.

What Mattarella might think:

  • Is the short-term benefit really worth it?

What the markets say:

  • “Mattarella should now do his utmost to secure a technical coalition to implement the 2020 draft budget with a cooperative stance toward the EU,” say Commerzbank strategists Michael Leister and Christoph Riegher in a note to clients. “Speculation on a caretaker government as well as quantitative easing should restore the tightening bias in BTP-spreads.” Italy-Germany 10-year yield spread narrows to 175 basis points, they say.
  • Singh of Crossbridge Capital believes the stocks will trade “sideways” as Italy will be “in a limbo” with a government that has no democratic mandate to make the necessary changes.
  • Chris Bailey of Raymond James calls it the “best solution,” which would fuel gains in stocks. “A reform-driven technocratic government is just what Italy needs. The trouble is, they have tried this before.“

3. Snap elections

Salvini’s League destroyed the field in the May European parliamentary elections, flipping the script on Five Star to take more than 30% of the vote. Buoyed by that result, Salvini pulled his support from the governing coalition this month, betting that a new national election would cement his grip on power.

Pros:

  • Polls suggest that the League could possibly win an outright majority, or at the very least put together a majority along with smaller parties on the right. That would suggest a more stable, lasting government than Italy is accustomed to.

Cons:

  • Elections at the end of October are unprecedented in Italy and would disrupt the process of approving the 2020 budget.
  • Salvini has signaled he’s ready to start a fight with the European Union over spending.

What Mattarella might think:

  • The president has been working behind the scenes to constrain some of the populists’ wilder instincts since they took power and he’s expressed irritation with Salvini’s political maneuvers. But he might think it’s time to give the League leader a free hand to see if he can deliver on all his bold talk.

What the markets say:

  • “Elections are definitely a negative outcome,” said Pooja Kumra, European rates strategist at Toronto-Dominion Bank. “Salvini in power could see BTPs going through same vulnerability as seen last summer.” Italy-Germany 10-year yield spread could climb as high as 280 basis points, according to the bank.
  • Equities will sell off initially as investors will expect Salvini’s government to clash with Brussels over the deficit, according to Brooks Macdonald and Crossbridge Capital.
  • A lot of the negativity is already priced in but a lot will depend on Salvini’s exact plan because a worst-case scenario for markets would be an excess of populism and an economic crisis, while a positive outcome would include lower taxes, says Bailey of Raymond James.

©2019 Bloomberg L.P.

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