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Somewhat encouragingly, in the run-up to the elections, Fratelli d’Italia leader Meloni took a more pragmatic stance on the most contentious issues. She has toned down her rhetoric on Russia and on Italy’s budget in particular. This is possibly the main reason why the financial reaction to the election result has been relatively muted, although as many in markets were busy digesting UK policy developments, the drivers are hard to disentangle. The Bank of Japan (BoJ) and Bank of England (BoE) have already intervened to avoid their own doom loops. The European Central Bank (ECB) may well be next and political developments in Italy make it more likely.
What happened: Populist coalition takes power with more pragmatic stance
In Italian elections on 25 September, the right-wing coalition secured sufficient votes to form a government, led by Fratelli d’Italia. This is set to be the most right-wing government in Italy for decades. And while the coalition’s policy agenda was significantly watered down during the campaign and Meloni appears to have taken a more pragmatic stance, her coalition partners’ views are more ambiguous.
On fiscal policy, while promising tax cuts, greater support for retirees (including via higher pensions) and for families with children, as well as more investment in infrastructure, Meloni has emphasised fiscal responsibility, indicating she is against increasing debt.
On energy policy, Meloni supports decoupling Italian gas and power prices as well as an EU-wide cap on energy prices and opposes her coalition partner - the League’s - plans for EUR 30bn of unfunded emergency support. As the UK experience now shows, unfunded fiscal stimulus might not be a good idea in any case.
On international policy, Meloni has previously taken a pro-Russian stance. However, more recently she has heavily criticised the Russian invasion of Ukraine and is likely to maintain this tough approach for now. Her partners’ views are more concerning, however, with both Salvini and Berlusconi holding a pro-Russian stance on several issues, including opposing sending weapons to Ukraine and sanctioning Russia.
On the EU, Meloni’s traditional Eurosceptic narrative has also shifted towards an overall friendlier stance. But the coalition has argued for the renegotiation of the fiscal rules within the Stability and Growth Pact and for renegotiation of the NextGen EU recovery package, among other pledges.
Our interpretation: new government faces market tests on Russia and Italian budget
How long this more pragmatic stance persists remains to be seen. With elections out of the way, attention now shifts to coalition negotiations which will last for at least a month. It is unlikely that the new government will become operational before the end of October, although the clear majority could help speed up the process.
This week, the Ministry of Finance is expected to unveil macroeconomic projections which will be used as a basis for an Italian budget draft that is due to be submitted to the European Commission (EC) on 15 October. Reports suggest that the incoming coalition is attempting to make significant changes to the 2023 budget but as the details are still being negotiated and highly uncertain, the outgoing Prime Minister, Mario Draghi, is resisting changes. An extension to the current deadline is possible. Investors will focus on deficit forecasts in the new budget, which will show the scale of the challenge for the new government - as well as for markets.
Once the government is up and running, Meloni’s first market test will be on the implementing of Draghi’s reform plan. A disbursement of more than EUR 19bn via the next tranche of the European Union’s National Recovery and Resilience Plan (part of NextGen EU) is expected in early 2023. However, each instalment is contingent on achieving several milestones (qualitative goals) and targets (quantitative goals). Draghi aimed to have met at least 50 per cent of these before leaving office. Any deviation by the new government that is not agreed with the EC could delay the next instalment.
Any "serious deviations from the satisfactory fulfilment" of these requirements would be raised at an EC meeting. But until the meeting was held, no payment would be made. This could take several months. Even if the EC decides to proceed with disbursements, missing just one of the requirements is likely to entail a wait of several months. Such a delay - or even a hint of tensions between the governing coalition and EU institutions - would almost certainly be a catalyst for markets to price in more negative scenarios.
Meloni’s second market test will be her stance on Russia and whether she can continue Italy’s support for Ukraine. Given the pro-Russia views she and her right-wing allies expressed previously, markets will be very sensitive to any deviation from Draghi’s stance on Russia.
Outlook: Central bank moves lower bar for ECB
With a range of crisis tools in its arsenal, the ECB is well-prepared. But the Governing Council will be reluctant to resort to the recently introduced Transmission Protection Instrument to control Italian spreads because of political issues, at least while the widening reflects a higher risk premium justified by the fundamentals. Any extreme moves threatening financial stability would spur intervention from the ECB, although it is unlikely to be entirely unconditional, which would undoubtedly be problematic for the new government.
That said, the ECB’s complex set of constraints - seeking to maintain its current hawkish policy stance aimed at taming inflation, while managing the war-related shock dragging the economy into recession - means it will not want to risk another peripheral debt crisis. And perhaps the latest interventions by major central banks - including the BoJ supporting the yen following its dramatic plunge in recent months and the BoE attempting to stabilise gilt markets in the wake of the UK’s ‘mini budget’ - lower the bar for an ECB intervention if warranted by market conditions.
Asset allocation views: Expect further policy interventions to prevent doom loops
Our asset allocation views have been cautious since March with underweights in equities and credit. Within equities, we have been underweight Europe versus the US. We have been positive on the dollar due to excess Fed hawkishness, but the current moves are looking disruptive and may lead to market interventions. The BoE has already blinked by announcing purchases of long-dated government bonds in whatever quantities are needed to restore order to the market. As market moves continue to be disruptive, we see further policy interventions on the horizon to prevent so-called doom loops from taking hold. The rise of the right in Italy makes the ECB the one to watch.