Political gridlock could weaken economic growth for 2018 but a supportive external environment will limit the fallout.

•  Italy enjoyed its strongest growth performance since 2010 in 2017, and lead indicators point to a continuation in early 2018.
• The remainder of this year is now more challenging given the messy election outcome, but the impact on the economy is likely to be limited by prevailing factors that supported growth in 2017.
• Likely electoral outcome is a grand coalition involving the centre-right bloc and PD.

The Italian economy surprised on the upside during 2017, expanding by 1.5%, the best performance since 2010. This was positive after Italy faced a toxic climate in late-2016, with a lost referendum on constitutional reform forcing the prime minister to resign and its banking sector riddled with record-high non-performing loans and a state rescue of several banks with potentially damaging consequences for small savers. 

However, economic activity was lifted by improving domestic and external demand conditions during 2017, while the bank rescues was less punishing than originally anticipated. Furthermore, elevated economic sentiment in tandem with robust purchasing managers for both services and manufacturing firms signal continued solid growth in early 2018. 

But, the outlook for the remainder of 2018 is now more challenging following the indecisive general election in early March.  The main parties or coalitions failed to secure a parliamentary majority on their own. The biggest gains were enjoyed by the  populist parties, in particular the Five Star Movement, which won one-third of all votes, and the anti-immigrant Northern League, with about 18% of the vote, outperforming its coalition partner, Silvio Berlusconi's Forward Italy, which secured about 14%. The centre performed poorly, with the ruling centre-left Democratic Party securing 19% of votes.   

Heightened political squabbling threatens to tilt back recently improved business and consumer confidence, which has stood up well to stagnant real wage growth, higher than normal unemployment and uncertain job security. Nevertheless, the immediate impact on the economy is likely to be moderate, with political gridlock mitigated by low sovereign and private borrowing costs, alongside Italy continuing to exploit strong economic conditions across the Eurozone and the global economy.   

Political disruption could hit growth in the second quarter, and strengthens our assessment that the pace of growth probably peaked in early 2018.  We will lower our 2018 growth projection by at least 0.1 point to 1.3% in the March update. Lack of political clarity could lead to firms delaying investment plans. However, we anticipate limited damage to investment, with firms enjoying strong output developments, rising capacity utilization and improved external demand.    

Italy has some firewalls while navigating through its latest political crisis. The economic impact is likely to be limited by prevailing factors that supported better growth in 2017. Low inflation environment remains, and is helping households to adjust to moderate earnings growth. Also, policy backdrop is supportive, with very low borrowing costs providing some comfort to rattled consumer and business confidence.  

 In addition, we assume that the post-election shuffle is likely to deliver a grand coalition involving the centre-right bloc and PD, which is a market-friendly outcome. Indeed, the euro and the Italian 10-year bond yields have been unmoved since the election.

The main pressure point remains banks’ share prices, with investors worried about any delay to reforming a sector swamped with bad bank loans and excess capacity, while hit on growth could ramp up the pressure on bank loans that are just performing.

A broad-based coalition government could be less dynamic, hindering progress on further labour market or banking-sector reforms. Also, a prolonged political stalemate would damage longer term growth prospects. Worryingly, voters are reluctant to support painful measures to tackle Italy's still lagging trend growth or more austerity to place its public debt pile on a more sustainable path. The populist parties have distanced themselves from policies to improve Italy's ability to function more effectively in the euro trading bloc.   

We assign a low probability of new coalition government consisting of the Five Star Movement and the Lega parties. This would ramp instability given their past euro criticisms, highlighted by effectively tapping into euro fatigue during the election campaign. Even under such a populist government, the process to undo Italy’s Eurozone membership would be arduous due to legal and constitutional safety nets before dismantling international treaties. Still, such a coalition would unsettle some companies based in Italy; concerned about a potential loss of free market access to EU should this be a beginning of a roadmap to a euro/EU referendum in Italy.