Investment Research — General Market Conditions 28 May 2018 Italian Election Monitor Five Star-League government steering towards a clash with the EU

 Markets are set to focus on any indications by the new Five Star-League New Italian government team government on its policy agenda and priorities in coming days and weeks.  Prime Minister: (technocrat,  We expect to see clashes between the Italian government and the EU on the law professor) economic ruleset over coming months.  Economy/Finance Minister: (technocrat, professor)  Abandonment of fiscal prudence could trigger more rating action in coming weeks.  European Affairs Minister:  We recommend clients take a cautious stance on BTP and focus on other markets (technocrat and controversial original choice such as Spain or France, both of which have widened to Germany/swaps. We for Finance Minister) expect EUR/USD to retest the 2018 low at 1.1510 over coming weeks.  Interior and Deputy Prime Minister: (League) Following days of uncertainty, the and League yesterday renewed  Labour/Economic Development and Deputy their coalition deal and received approval for their cabinet from President Sergio Prime Minister: (Five Star) Mattarella. Although the initial market reaction was positive, as political uncertainty subsided  Foreign Minister: along with the risk of a new election, we think there will be more struggles ahead and believe (technocrat, ex-European Affairs minister that markets will continue to be very headline driven over the next few weeks and months. under Mario Monti)  Defence Minister: (Five EU relations—confrontations likely Star) The new government will be a combination of technocrats and politicians (see box Source: Bloomberg above right). Following the row with the President over the appointment of Paolo Savona as Finance Minister last week, party leaders agreed on an alternative in the person of Giovanni Tria. Currently an economics professor at ’s Tor Vergata University, he is a relatively unknown figure and reported to be close to centre-right circles. In an opinion piece in March 2017, Tria previously advocated monetary financing of government deficits if funds are spent on investment, which would be illegal under EU treaties. This leaves us to expect that he will not be averse to higher fiscal spending as envisioned by the new government. This said, we will need more information about his fiscal policy priorities and hence any comments from him in coming days and weeks on the topic of spending proposals and the relationship with the euro/EU will be of key market focus near term.

Positively, Tria is not considered an outright eurosceptic: although he has previously called for a debate on the euro in both and the rest of Europe, he is not in favour of an outright Analyst euro exit (‘the greatest danger is implosion, not exit’). Instead, changing the economic rulebook Aila Mihr of the euro area is likely to be the focal point rather than leaving the euro area. +45 45 12 85 35 [email protected] While the risk of an Italian exit from the eurozone is less likely, we think the new Global Head of FICC Research government will clash with Germany and other hawkish EU countries on the EU Thomas Harr economic ruleset. The reaction of other European countries will depend on how reasonable +45 45 13 67 31 [email protected] they consider the new Italian government. There are some proposals that will be a ‘no go’ for the EU, such as monetary financing of deficits given the EU treaties and significant Chief Analyst Jakob Ekholdt Christensen breaches of the EU deficit rules. However, on the other reform proposals such as larger EU +45 45 12 85 30 public investments and more fiscal flexibility, the European reception of these proposals [email protected] will depend on two things: (1) the new Italian government seems to respect the EU deficit Chief Analyst rule (i.e. funds their spending proposals and income tax reforms with higher taxes in other Arne Lohmann Rasmussen +45 45 12 85 32 areas) and (2) that they pick a few initiatives and do not go overboard. [email protected]

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Italian Election Monitor

Remember that France is advocating some of the same ideas on euro area integration but doing this while putting its own house in order. If the new Italian government does not do this, then it will be very difficult for France to ally with Italy and it will be an even clearer ‘nein’ from the German side. Our base case is that confrontations between Italy and Germany will be quite significant. What to look out for in the next weeks and months? The cabinet is due to be sworn in today at 16:00 and then it will face confidence votes in parliament on Monday and Tuesday. As the Five Star-League coalition has a majority in both chambers of Parliament, we think this should not constitute a big hurdle.

The euro group meeting on 21 June will surely be interesting, in terms of both the reception that other euro area finance ministers give Tria and the strategy line Italy chooses at these meetings. The next focal point is the heads of states meeting at end-June, when euro area integration and the next EU budget will be on the agenda. Surely, EU officials will now look at this meeting with heightened concerns. What may also be controversial is the renewal in early August of sanctions on Russia for another six months, which would require unanimous support from all EU countries and the new Italian government has more pro-Russia sentiment.

Another key market focus in the near term is any indication from the new government on its policy agenda and priorities. We still think it will be difficult for the Five Star- League coalition government to implement fully its programme in its current form (see also Italian Election Monitor – Rising market pressure set to challenge spending plans, 24 May). One of the government’s first tasks will be to start working on the 2019 budget, which needs to be approved in the autumn and submitted to Brussels by 15 October.

Should the populist government not temper its spending proposals, we could see more action from the rating agencies. Moody’s has already placed Italy on negative watch and a downgrade to Baa1 might come within weeks, if fiscal prudence is abandoned.

Timeline: Italian and EU events to watch out for

Confidence votes on new Government in Parliament 4/5-06-2018

Conte’s new government Italy to submit 2019 sworn in budget to Brussels 1-06-2018 Sep/Oct- 2018

Italy event May Jun Jul Aug Sep Oct Nov 2018 EU event Today

21-06-2018 Eurogroup meeting: First meeting between new Italian MoF and rest 1-08-2018 of finance ministers EU sanctions on Russia renewal: EU to renew for 6 months, which requires unamious support among all Eu 28 countires. The new Italian government 28/29-07-2018 quite pro-Russia. European Council meeting: Discussion of euro integration and EU budget

Source: Danske Bank

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Italian Election Monitor

BTP market continues to be headline driven – we remain cautious on Italian bonds Overall, Italian yields are now lower than before the close on Monday, when the sell- off started, and the curve has continued to steepen this morning. We agree with the initial market positive response, as we now have a government in place after months of uncertainty. The BTP market will continue to be alert to headline news on a possible revised fiscal policy programme and comments from rating agencies.

However, the genie is out of the bottle and we would recommend clients take a cautious stance on Italian bonds, until we have more clarity on a revised policy programme. We would rather focus on other periphery markets such as Spain or Portugal, where volatility-adjusted returns look more interesting. We are less concerned about the no-confidence vote against Prime Minister Rajoy today. We are likely to have a government led by the Socialist leader Sanchez and a new election within the next 12 months. However, in contrast to Italy, this could actually lead to a more stable and pro- European majority government emerging and the underlying fundamentals remain very favourable in Spain. France is another possibility after French bonds have widened. EUR/USD set to fall back near term

Meanwhile, EUR/USD is currently trading higher than it closed one week ago. EUR/USD has been falling recently for a range of different reasons, with Italy being only one of them. Even if the Italian factor takes a backseat, we think the short-term factors for a lower EUR/USD near term – high USD carry and long EUR/USD positioning – remain intact. We expect EUR/USD to fall back over coming weeks towards the low of 1.1510 reached on 29 May.

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Italian Election Monitor

Disclosures This research report has been prepared by Danske Bank A/S (‘Danske Bank’). The authors of this research report are Aila Mihr (Analyst), Thomas Harr (Global Head of FICC Research), Jakob Ekholdt Christensen (Chief Analyst) and Arne Lohman Rasmussen (Chief Analyst). Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. Danske Bank’s research reports are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank’s research policies. Employees within Danske Bank’s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank’s Research Departments are organised independently from, and do not report to, other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates None. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research report has been prepared by Danske Bank (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) (‘Relevant Financial Instruments’). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided herein. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank’s prior written consent.

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Italian Election Monitor

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Report completed: 1 June 2018, 11:16 CEST Report first disseminated: 1 June 2018, 12:20 CEST

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