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March 2018 | Jens Larsen, PhD, Macroanalyst; Eoin O’Callaghan, Global Bond Strategist

Germany opens a path to eurozone reforms; Italy clouds the picture

While we think the market may be underestimating the potential benefits of proposed structural reforms, the Italian election result has also raised the risk of a populist government delaying or derailing the reform process.

Key points

  • The vote for a grand coalition government in Germany is likely to lead to a more expansionary fiscal policy and opens up a path to substantial reform of the eurozone.
  • If agreed and implemented, these reforms could support a stronger euro, narrower sovereign spreads and lower risk premia in normal times.
  • The strong performance of populist parties in the Italian election will complicate the process and is an obstacle to overcome, as the next Italian government is likely to have a more volatile and confrontational relationship with Europe than in the past.
  • The rise in populism also increases the risks around Italy’s public debt trajectory. Italian assets are still benefiting from strong growth and expansionary monetary policy, but rising political risk will become more important during the next downturn.

SUNDAY MARCH 4 WAS A BIG DAY FOR EUROPE, with important votes in Germany and Italy producing conflicting results. We believe that the vote for a grand coalition in Germany will usher in a significant change in domestic policy, which should be positive for European assets in the medium term, and also paves the way for important structural reforms within the eurozone. The strong performance of the populist parties in the Italian election complicates the process and is an obstacle to overcome.

German policy is changing domestically…

We expect Germany’s new coalition government to pursue a more expansionary fiscal policy that will support the rebalancing of the European economy. Germany’s fiscal position is extremely strong. With the Social Democratic Party (SPD) joining the coalition, the Finance Ministry will come under its control, and we expect fiscal policy to be loosened substantially over the next two to three years, with tax cuts and additional health and social spending followed by education spending and ultimately investment. In addition, the policy measures in the coalition agreement will, we think, tend to reduce the competitiveness of the German economy compared with its European partners. That could help rebalance economic growth; it should also be supportive of risky assets in general and in particular of exporters in countries — like France — that should benefit relative to Germany.

…and on the eurozone

A new German coalition government is also likely to shift its stance on eurozone reforms. Concerns about the reform proposals launched by French President Emmanuel Macron in the autumn of 2017 have not disappeared: Germany still wants risk reduction before risk sharing, is worried about fiscal transfers and is uneasy about a common deposit insurance scheme to back all European banks.

Nevertheless, attitudes have changed profoundly from even six months ago. The strengthening eurozone economy and improvements in banks’ capital positions and non-performing loans have helped. But Germany’s political priorities have also changed, with external borders, refugee policy and security and defence taking centre stage. And the new coalition appears to understand that advances in these areas must go hand in hand with reform of the economic and monetary union (EMU).

In our view, substantial progress is likely over the coming months in the following areas:

  • Completing the banking union — We expect agreement in principle on using the European Stability Mechanism (ESM) as a backstop for the Banking Union Resolution Fund and eventually for a European deposit insurance scheme. Over time, this should lead to an integrated European banking sector where deposits and capital can move around countries. Consolidation in the sector would be likely.
  • A European Monetary Fund — The ESM is likely to be strengthened, creating a European Monetary Fund. This may include a framework for handling future bailouts, possibly with the power to call for a restructuring of sovereign debt where it is deemed unsustainable. That could cause concerns in Italy, which is most likely to face deteriorating fiscal dynamics in an economic slowdown.
  • Fiscal capacity for support — The eurozone may inch towards sharing cyclical fiscal risks by providing some form of support to countries suffering a rapid economic deterioration.

What does this mean for the markets? Taken together, these political developments point to higher bund yields, tighter sovereign spreads and euro strength. We also believe that progress on these reforms would reduce the risk of a repeat of the sovereign crisis and dampen fears about a possible future break-up of the eurozone. We would therefore expect reform progress to underpin euro assets in general, but be particularly beneficial for the European banking sector.

Italy clouds the picture

Sunday’s election produced a hung parliament in Italy. The clear losers are the centrist parties, as the populist parties claimed over 50% of the vote, up from around 30% in the last election. The most likely outcomes are a government led by the anti-establishment Five Star Movement (with the Democratic Party or, less likely, the Northern League) or fresh elections. A centrist or technocratic government appears less likely.

Forming a government is likely to take some time as the president seeks to identify the party best placed to create a majority; in 2013, it took two months. If no government can be formed, he will call new elections. Paolo Gentiloni will continue as prime minister in the interim.

The implications for Italy…

Over the past 12 – 18 months, Italian assets have been underpinned by stronger growth, quantitative easing from the European Central Bank (ECB) and prudent policy from the Italian government (the last four administrations have made some reforms and run a persistent primary budget surplus).

The election result increases the risk that government policy becomes less of a support. A populist-led government is likely to be less fiscally responsible. Before the election, all parties were promising looser fiscal policy in an effort to stimulate growth. Five Star’s pledges included a minimum basic income, and a temporary increase in the deficit above 3% for two to three years. It is also less likely to be reform minded — Five Star has argued for the partial unwinding of some labour market and pension reforms. Finally, Five Star is also relatively inexperienced in government: where it has had an opportunity to govern, as in Rome, it has done so poorly.

If Five Star were able to form a coalition with the Democratic Party, it would address some of these issues and would be more likely to walk away from its campaign promises. But there would still be more uncertainty than normal — as “Movement” implies, Five Star is a fluid organisation that has frequently shifted policies over the past few years.

…and for EMU reform

Both Five Star and La Lega have toned down their Eurosceptic language in recent months. However, it is not clear how much of that is just an opportunistic response to the defeat of Marine Le Pen in France and a lift in the cycle. The new Italian government’s attitude to EMU reform is likely to be more unpredictable and possibly even hostile. In particular, proposals to make future bailouts possibly dependent on restructuring of sovereign debt could come under fire.


In sum, the German and Italian elections imply that both upside and downside tail risks have grown. While we believe that the market may be underestimating the potential beneficial consequences of EU structural reforms, the Italian result has increased the risk that these reforms may be delayed or diluted or derailed.

So far, the market appears to be engaging with the positive tail. The reaction to the Italian election has been muted, perhaps reflecting the positive news from Germany, continued ECB buying and the strength of the cyclical data. But the downside risks have grown too. It is striking that populist parties are becoming the main opposition in countries across Europe — and now potentially forming the government in Italy — even at a time of strong growth. This increases the potential for policy mistakes during the next global economic downturn.


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