Since then, Italian sovereign spreads have surged by about 200bp, sharply increasing the financing cost of the government. The Italian government plans to increase spending and lower taxes that will increase the fiscal deficit significantly in the years to come. However, it is clear when examining the growth assumptions underlying those estimates that the government is expecting a high fiscal multiplier from its stimulus. Those growth rates are about 0.5 percentage points higher than consensus and, as a result, private sector economists expect that the current fiscal plan will lead to a small increase in the debt-to-GDP of Italy. The EC has rejected the Italian government plan, arguing that it is in breach of the Eurozone’s budget rules, and has asked for a revision. This was met with defiance by the Italian government.

Our base case scenario is that Italy will remain in the euro area and that the Italian government will back down and present a budget that is compliant with the EU rules (who may also offer some concessions). However, the road to this outcome will be volatile and risky, especially since we believe the Italian government will only back down in the face of extreme market pressures, as opposed to pressure from the EC.

Essentially, we think the Italian government could end up playing a high-stakes game of chicken with the EC. The populist government understands that if Italy were allowed to fall out of the common currency that could cause significant collateral damage to the rest of the Eurozone, and it is likely expecting the EC to back down first.

In our view, this means further increases in Italian sovereign spreads, and on the Italian banking sector, are likely in the coming months. Furthermore, the risk of an accident remains high and cannot be discounted. The situation is further complicated by the fact that there are also rising tensions within the Italian populist coalition, especially with the League gaining national support at the expense of the Five Star movement, and this could potentially lead to an early election in 2019.

Political risk also abounds in the UK. On 29 March 2019, the UK will leave the European Union. But this is where the certainty ends. It remains unclear whether the UK and the EU will have an agreement in place by that date.

The UK and the EU have recently reached a tentative divorce deal. The details available suggest that the UK will remain closely aligned with the requirements of the single market, preventing the establishment of a hard border in Ireland. It is not yet clear whether the deal will make it through parliament. The domestic political risks in the UK remain elevated.

Recent political developments witnessed in the aftermath of Prime Minister May’s push for a deal indicate that the most pressing issues have not been resolved and uncertainty around Brexit has once again risen sharply as the deadline nears.

While at this stage, it is still unlikely a new referendum will be held – either on the EU membership itself or on the Brexit deal – the consequences of parliament voting against an agreement would be important and could derail the process.

There are also some political risks on the European side too. We continue to think that ultimately a deal between the UK and EU will happen as all sides have an incentive to push the negotiations to the very end. However, the road to a deal is likely to see pressure on UK assets as they become a party to the ’chaos’. 

If a sensible Brexit is delivered, we see GBP rising to 1.40 and potentially even higher next year
with the possibility to be a big winner of 2019. That said, in the event of a “blindfolded” Brexit, we expect GBP to fall by another 10% as the currency adjusts to reflect the new uncertain reality facing the United Kingdom.

Download the Global Outlook 2019.