Investors' Outlook October 2018

Investors Outlook , Multi Asset 10/1/2018 by Christophe Bernard
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Italy: Wrong Turn

Italian investors have expressed their discontent by selling Italian assets „en masse“ since Movimento Cinque Stelle (M5S) and Lega agreed to form a governing coalition. In particular, the potential implementation of spending plans in excess of 5 percent of GDP have given cause for concern as they would represent a clear breach of the EU stability pact and jeopardize the long-term sustainability of Italian government debt. As a result, bond investors have pushed the spread between Italian government bonds (BTPs) and German Bunds to levels last seen during the euro zone crisis (see chart 1).

The proposed draft budget for 2019 foresees a deficit of 2.4 percent of GDP, higher than the 1.6 percent deficit economic Minister Tria was fighting for, but complies with the maximum 3 percent Maastricht deficit rule. However, such a deficit will not allow for a reduction of Italy´s elevated public debt and might rely on over-optimistic assumptions (the budget details have not yet been released as at time of going to press). As a result, we expect a push-back from the European Union and protracted negotiations. Overall, we expect the interest rate differential between Italy and Germany to hover around current levels in the near term, but we would not rule out episodes of spread widening if bond investors question the long-term impact of the coalition´s policies.

The longer term view paints a different picture, however, as much of the progress that Italy has made since 2015 could be undone. For one thing, the „DNA" of both M5S and Lega - as outlined in their respective election platforms - is against the EU, or even Euro membership. Moreover, Italy's debt sustainability and growth potential are at risk. Even though the Italian debt pile is substantial at 130 percent of GDP, the country generates a significant primary budget surplus (before paying interest on the debt), disposes of a significant pool of national savings and runs a (small) current account surplus. The key to debt sustainability is to keep interest rates low to allow cheap refinancing and, above all, to grow the economy. The lack of sustained economic growth is Italy's Achilles' heel. The country basically posted zero growth between 2000 and 2014 with entrenched labor market rigidities, an overblown state apparatus and an inefficient judiciary being the root cause of stagnation. However, the introduction of the Jobs Act by the Renzi government in 2014, which, together with the Fornero pension law enacted during the height of the Eurozone crisis, brought some welcome structural reform. With the tailwind of a global recovery, Italy's economy managed to grow at 1.3 percent per year between 2015 and 2017 – which is not great by European standards, but definitely an improvement relative to Italian ones.

Alas, the first significant measure introduced by the new coalition, the so-called „dignity decree" has unwound key aspects of the Jobs Act, triggering an angry response from Confindustria, the Italian employers union. The coalition also intends to lower the retirement age, contributing to a deterioration of the country's long-term competitiveness. Since the introduction of the Euro in 1999, Italy lags behind with respect to the development of unit labor costs (see chart 2). This does not bode well for trend GDP growth, and more broadly, for long-term debt sustainability. Certainly, debt sustainability could still be achieved, provided one has a potent buyer who is willing to provide refinancing and low interest rates (like the European Central Bank (ECB)). However, the ECB re-iterated its intention to terminate its bond purchases at the end of 2018, leaving Italy vulnerable to the vagaries of the bond market.

Admittedly, an early election, which would not be such a surprise given the often opposite view of Lega and M5S on important matters, might change the situation for the better, but this is pure speculation at the current juncture. In addition, the political opposition needs to regroup after a bruising electoral defeat.

In sum, while the short-term outlook for Italy might be relatively calm, a storm is brewing in the long-term and Italy is likely to hang like a sword of Damocles over European financial markets.