Italy’s economic rebound continues amid political uncertainty

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

As Italians head to the polls to designate their next government in 2018 under a new electoral system, we believe unstable politics should not harm economic progress. However, the country still faces numerous structural challenges in the long-term.

70 years of unpredictable politics

The Italian political system was founded in 1948 after the Second World War. Italy’s political parties made every effort to prevent the establishment of an authoritarian government by strengthening the legislative branch. And so the proportional representation system was born. In its 70 years of existence, the system has benefited minor parties and resulted in unstable coalitions: 62 governments have sought to rule the country since 1948, with an average tenure of approximately one year.

Rosatellum Bis: the new electoral law

The country has tried to put an end to political instability by attempting to modify its electoral rules a few times since 1993, but has never entirely succeeded. In October 2017, a new electoral law called Rosatellum Bis was adopted for both houses of parliament. It is a one-round voting system in which 36 percent of seats will be allocated using a “first-past-the-post”, winner-takes-all system, and 64 percent will be assigned proportionally. The law introduces another crucial change: single political parties and campaign alliances need to reach at least 3% and 10% of the votes, respectively, to be elected. The threshold largely favours mainstream parties capable of forming alliances before the ballot, and penalises parties that reject coalitions, such as the 5-Star Movement (M5S). However, even though uncertainty is the norm in Italian politics, we believe that the likelihood of M5S scoring a major victory in 2018 is rather low. Italy’s main anti-establishment party is facing quite an insurmountable barrier – the combination of a new electoral system, the party’s strong stance against alliances and its poll figures, which have consistently remained below 30%.

First electoral test in Sicily

Recent regional elections held on 5 November on the island of Sicily were an important barometer of voting intentions ahead of the general elections vote next year. Centre-right parties won 39 percent of the ballots with a broad coalition involving Silvio Berlusconi’s Forza Italia party, the Brothers of Italy and the Northern League. In second place was M5S with 35 percent of the votes, leaving the centre-left alliance behind with only 19 percent of the votes. This result has pushed Silvio Berlusconi back into the spotlight after years of political controversies, and has given hope to Italy’s centre-right parties. There is a chance that these parties may choose to run jointly in the 2018 general election, and take advantage of the Rosatellum Bis law.

Economic recovery carries on

For all its political woes, Italy is undoubtedly on the path of economic recovery. The momentum is strong with expected real growth of 1.8% in 2017, up from 1.0% in 2016. Unemployment has slightly improved from 11.8% in 2016, and is headed for an expected level of 11.1% at the end of this year. And with forward-looking indicators such as the PMI¹ surveys consistently in expansionary territory, the recovery looks set to persist. The Italian government deficit has also marginally decreased from 2.6% in 2016 to 2.5% in 2017. With more growth, an improving jobs picture and a slightly lower public deficit, the Italian economy warrants optimism in the short term.

Even if Italy’s outlook is improving, the country still has a lower growth potential compared with the euro area average due to its many structural issues: high levels of debt, weaknesses in the banking sector, a rigid labour market and an ageing population. With an average zero growth of GDP per capita since the introduction of the euro in 1999, the Italian economy is often labelled the sick child of the eurozone economy.

Italian banks on the mend

We believe Italy can address its structural concerns with serious political impetus. Recent developments in the banking sector are a good example. While Italian banks suffered from record levels of non-performing loans (NPLs) in 2016, the government initiated a series of reforms to address the issues, such as state guarantees and the bankruptcy reform. In addition, certain banks have been either recapitalised (Monte dei Paschi di Siena), resolved (Banca Populare di Vicenza and Veneto Banca) or are raising capital to accelerate the disposal of their NPLs (Unicredit has already done so, while the process is underway at several smaller banks). The decrease in NPL levels is making the banking sector more resilient. However, additional progress is still required, and we believe the 2018 general elections to be decisive in this regard.

While anti-establishment parties might struggle to win votes under the new electoral system, Italy’s political landscape remains highly fragmented, and a negative electoral surprise is still possible in 2018. Should such an event occur, the euro could come under pressure and political uncertainty could fuel investors’ fears regarding the current positive momentum both in Italy and in the euro area. We believe that general elections should not disrupt the positive economic trends in Italy although political uncertainty is bound to add market volatility. We remain confident in the strong momentum of the European economy, and continue to favour European equities in private clients’ portfolios.

¹ Purchasing Managers’ Index (PMI)
Source of all data: Bloomberg