Election preview - Italy heading for a right-wing coalition

Political instability to continue in Italy

Since the collapse of the Draghi government, polls for the election have persistently given a comfortable majority (of around 245 of the 400 seats in the lower house and around 120 of the 200 seats in the upper house) to a right-wing coalition, with the far-right Brothers of Italy led by Georgia Meloni as the dominant party in the coalition. The Brothers of Italy will be joined in the coalition by the League (led by Matteo Salvini) and Forza Italia (led by Silvio Berlusconi). One of the main issues on the agenda of this new government will be whether it will stick to the policy changes that were agreed with the European Commission in the country’s recovery and resilience plan. According to these plans, Italy would receive around EUR 190bn (equal to almost 11% of 2021 GDP) in loans (around EUR 120bn) and grants (around EUR 70bn), which could raise GDP growth by roughly 3.5 percentage points during the period 2021-2026.

Considering that the Brothers of Italy has not been in government before, whereas the League and Forza Italia have been in government before (Forza leader Silvio Berlusconi has been prime minister for four governments in the past) and also taking into account the ideological differences between the three parties (e.g. Brothers of Italy emerged from a right-wing split within Silvio Berlusconi's party around a decade ago), there seems to be a significant risk of infighting within the government, meaning that Italy’s long history of political instability could very well continue.   

Rates impact: What does this mean for BTPs? 

BTP yields have already risen by more than 300bps since the start of the year, now crossing the 4% level on the back of a rising rates environment. Generally, we judge that markets have now priced in a right-wing coalition winning the election with Georgia Meloni as its lead.  Despite the fact that there seems to be no discussion of an Italian exit and/or a strong anti-EU agenda from the right-wing coalition, there is still some uncertainty looming for the upcoming months. First, Meloni’s controversial stance on how she intends to use the EU recovery funds and her measures regarding the energy market, signal that there could be some tensions arising between her government and Brussels if she is indeed elected Prime Minister. Second, forming a viable government will not be simple. Reconciling diverging views of coalition partners on Russia for instance or regarding fiscal policy will be challenging. Georgia Meloni already said that she does not intend to take on more debt, whereas Matteo Salvini has said that he is willing to increase the deficit to support people through the energy crisis. Furthermore, the deadline for the first budget is coming soon, set in December 2022. Therefore, getting an agreement, especially on fiscal discipline is unlikely to be achieved without turmoil.  As a result, we expect BTP-Bund spread to widen during and post-election results until the political uncertainty eases, which we do not expect to happen before at least H2 2023. We forecast the BTP-Bund spread to widen up to 280bps by the end of this year due to the combination of political tensions and the economic recession in the eurozone, which is likely to trigger a flight-to-quality. Thus, given our forecast for Bund yields (see here), this implies a rise in BTP yields to 4.35% by year-end, from 4% now.  Thereafter, we expect the BTP-Bund spread to remain elevated in the first part of 2023 before tightening again in the second half of the year once economic conditions in the eurozone improve and the political uncertainty and tensions in Italy dissipate. One caveat applies though to the latter - whether a budget has been agreed on, and most importantly, approved by the European Commission. If so, we expect the BTP-Bund spread to tighten back to 220bps end of 2023.