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Italie : Stagnation, pas de récession

Key points:

  • Italian politics are back at centre stage, with Lega party leader Matteo Salvini unexpectedly triggering a government crisis and making way for what in many ways is yet another spurious coalition. The positive political climate, more European Union-friendly, together with non-negative – although weak – growth should be encouraging for markets.
  • However, experience shows winds can quickly turn in Italy. The Democratic Party-Five Star Movement coalition is at risk of being subject to populist outbids and might suffer from internal party divergence, questioning its ability to last beyond the next few months.
  • Structural reforms are unlikely to be adopted by this type of government, so structural weakness will continue to weigh on the medium-term outlook. Italy remains trapped in a low growth/high debt environment, and we should not be lured by the recent decline in yields. Sound fiscal policies consistent with solid primary balances are needed, even just to stabilise public debt.
  • A global yield-grab, aided by further European Central Bank accommodation, together with clearly improving investor sentiment toward the new, Europe-friendly government coalition is likely to provide ongoing support to the Italian government bond market.

 

Stagnation, not recession

Having entered recession at the end of 2018, the Italian economy surprised slightly to the upside in the first half of 2019. Depressed survey data and a deteriorating industrial sector suggested negative growth in the second quarter (Q2), after the 0.1% quarter-on-quarter (qoq) growth in Q1. But Q2 GDP was flat, and the expenditure breakdown reveals that a positive contribution from investment (mainly due to construction) was offset by some destocking. Net trade was flat, while private consumption growth stagnated.

Looking ahead, we expect a broadly similar pattern, with growth hovering around current levels of 0/0.1%qoq. This would bring the 2019 annual average to 0.1% year-on-year (yoy) and would be consistent with a slightly stronger growth of 0.4%yoy in 2020 (consensus: 0.5%). This may not be cause for great celebration, but at least is no longer an outlook for contraction. Reduced – but still persistent – political uncertainty, the global trade slowdown and structurally low potential growth should keep a lid on economic growth.

On the domestic demand front, private consumption is likely to remain depressed. Deteriorating employment expectations and rising consumer saving intentions suggest that the potential boost from the universal income scheme introduced in April is likely to be limited. Business investment has suffered from poor business confidence, tighter financing conditions and weak demand. It fell from an average growth of around 4%yoy in the first half of 2018, to around 0% since. But a slight improvement on these three factors should prevent a further drastic fall, albeit without spurring a significant recovery.

The latest European Central Bank (ECB) bank lending survey was encouraging, with credit demand picking up and credit standards easing. Financial conditions should also benefit from the much-expected new round of monetary policy stimulus from the ECB and the more European Union (EU)-friendly stance of the new government. Business confidence has tentatively stabilised and demand expectations have improved a bit from low levels. True, this might be due to firms lowering their selling prices (Exhibit 1) and squeezing profit margins is not usually a positive for investment. But domestic industrial new orders have turned positive again, suggesting that internal demand is recovering. We therefore expect investment growth to be slightly positive, although still impaired by the weak external environment – foreign new orders are 6 percentage points (ppt) lower than the 2018 average.

Indeed, with a large part of the economy dependent on the manufacturing sector (industry ex-construction accounts for around 20% of GDP) and elevated exposure to Germany (correlation with German industrial production stands at 83% for the 2000-2019 period), Italy is feeling the hit of the global trade slowdown (Exhibit 2). The latest trade war developments and persistently poor German data signal that the external sector will remain a drag to economic activity, with risks skewed to the downside.

A better than expected deficit outcome

Fiscal data surprised to the upside in the first half of the year, and the Q1 deficit as a percentage of GDP was below that of 2018. This was mainly due to the decline in interest payments (Exhibit 3). Tax revenues also helped, quite surprisingly given the deceleration of the economy. And despite the strong rise in the primary expenditure ratio compared to a year ago, it was still lower than projected by the government. Better-than-expected cash balances were actually one of the reasons that allowed Italy to escape the opening of an Excessive Deficit Procedure back in July.

Looking ahead, Italy’s public accounts are likely to deteriorate in our view, bringing the 2019 deficit higher than the 2.0% government target, but less so than we initially projected (2.2% vs. 2.4% of GDP). Two opposing forces will be at play. The cumulative disbursement of the citizenship income – which only started in April – and early retirement schemes, as well as ongoing economic weakness – the unemployment rate rose to 9.9% in July – will push up primary expenditures. Meanwhile the ECB-induced decline in yields will continue to provide fiscal space (more on that below).

EU and Italy to be friends again

On the political front, the worst-case scenario of snap elections in the middle of the Budget season leading to Matteo Salvini as the next Prime Minister seems to have been avoided for now. The exiting Prime Minister Giuseppe Conte has formed a new government, that will face a confidence vote in the Lower and Upper Houses on Monday. The new Five Star Movement (M5S)- Democratic Party (PD) coalition should be able to theoretically count on some 348 deputies in the Lower House (111 PD, 216 M5S, 14 Free and Equals and 7 mixed group – majority threshold 316), and 168 seats in the Upper House (51 PD, 106 M5S, 11 others – majority threshold 161), broadly similar to the previous government (Exhibit 4). While passing the Lower House vote should be straight-forward, the Upper House is likely to be a tighter outcome.

We had considered the 2020 budget as a major challenge for the previous government, given its ambitious fiscal pledge. The new MS5-PD government should make compromise with the EU more achievable. Budget discussions have just started, and no numbers have yet been pencilled in to the new government’s 26-point programme. But it seems that the removal of the flat tax, the Lega party’s flagship proposal – which would have resulted in an estimated revenue loss of €15bn, circa 0.9% of GDP – will be used to avoid the 3ppt Value-Added Tax hikes – worth around 1.3% of GDP.

As previous episodes have taught, Italy’s stance towards Brussels matters a lot and is sometimes more important than the precise numbers. The M5S-PD cooperative position might push the EU to adopt a more conciliatory tone, especially as failing to provide some fiscal leeway could benefit Lega. Indeed, asking for a large consolidation effort – EU rules require a 0.6ppt structural balance adjustment in 2020 – would increase the risks of a near-term government crisis, while suggesting that cooperation with the EU is not worthwhile. Salvini’s anti-EU rhetoric would be reinforced. On top of the domestic political considerations, the external environment is also more favourable, with a tentative consensus slowly emerging on the need for more fiscal support amid the European slowdown and monetary policy limitations.

We thus expect the M5S-PD government and European Commission to agree on a 2020 deficit target of around 2.1% of GDP, achieved through lower interest rate payments, some cuts in government spending and some reorganisation of the tax system. Reduced confrontation with the EU also means that the risks of a sovereign rating downgrade fade in the near term. Moody’s Is due to complete its review of Italy’s Baa3 stable rating on 6 September while Standard & Poor’s, which rates Italy as BBB negative, will update on 25 October. In our view, we would need to see the re-emergence of euro exit threats for rating agencies to downgrade Italy further.

But Italy remains on the razor’s edge

A fragile political stability…

Political instability is a distinct feature of the Italian landscape and no change is expected on that front, particularly given the new government’s expected slim majority.

PD and M5S are historic rivals and one main risk is that this coalition – inconceivable a few months ago – spurs internal party divergence, eroding the slim majority and leading to a future political crisis. For instance, we could see PD imploding, with former Prime Minister Matteo Renzi forming his own party and M5S giving back the shares of votes fetched through the promise of a universal income. This might lead to new future elections and a polarisation of votes toward the centre right. In addition, Salvini may benefit from being in opposition by continuing to court the electorate with his populist pledges - the evolution of the polls will be key to gauging the various players’ incentives.

…unlikely to address structural weakness

If political uncertainty is a key feature of the Italian economy, it is joined by the weak growth/high debt vicious circle. Indeed, the underperformance of the Italian economy has deeper roots than political gyrations and external weakness. It also lies in structurally low potential growth. Total factor productivity has been anaemic since the 1990s and remained well below its pre-financial crisis level (Exhibit 5).

Poor investment growth following the double dip recession means that the net capital stock has remained broadly flat since 2008, compared to a circa 10% increase in the euro zone as a whole. Firms’ productivity and investment have remained impaired by structural rigidities, including an inefficient public sector, burdensome regulation and complex and high taxation, as well as political uncertainty. These factors are behind the poor performance of Italy in the World Bank’s ‘ease of doing business index’, where it ranks 51st in 2019, the fourth lowest in the euro area.

This business environment, non-conducive to investment, is further compounded by a misalignment between wage and productivity growth. Cost-competitiveness has failed to improve significantly over the past few years, despite the moderation in nominal wage growth.

The main culprit has been persistently weak labour productivity. Low capital intensity has weighed on productivity and our depressed investment projections suggest that it is unlikely to turn supportive any time soon. More importantly, the structure of the labour market is a source of concern. Even though it has improved slightly over recent years, Italy’s labour force participation rate remains the lowest among euro area countries, and its employment ratio still stands more than 12ppt below the euro area. In addition, temporary employment is on the rise at 13.4% – most of the employment growth since 2017 has been due to short-term contracts (Exhibit 6). This double trouble of low supply – likely to worsen given Italian demographic projections – and the lower quality of labour – temporary contracts are on average less productive than permanent employees – bodes bad for future productivity growth.

As repeatedly highlighted by institutional organisations, a package of decisive structural reforms – including decentralising wage bargaining and liberalising product and service markets – would be needed to lift potential growth. We do not believe that the fragmented political landscape will allow this to happen and thus continue to expect low productivity, investment and potential growth compared to euro area peers, with potential growth for Italy at 0.5% versus 1.1% for the euro area. This matters a lot for the fiscal outlook.

Plus ça change plus c’est la même chose

Indeed, what matters for debt sustainability is the interest rate-growth differential. Yes, it has narrowed compared to the financial crisis, but it is still positive (Exhibit 7) and expected to remain so. Thus, stabilising public debt requires fiscal policies that ensure persistent, positive primary balance.

True, historically the primary balance surplus has been elevated in Italy, averaging 1.8% of GDP since 1999, compared to only 0.4% of GDP in the euro area. But as Exhibit 8 shows, primary balance surplus and growth failed to outpace the interest burden[1] for the entire period after the crisis.

In Exhibit 9, we look at the primary balance surplus that would be needed to stabilise public debt at the 2018 level for various growth-interest rate combinations. Against the current economic environment, a primary balance surplus in excess of 2% of GDP is still required to stabilise debt at 132% of GDP. This is higher than the European Commission forecast and what is planned by the government in the April Stability plan (1.5% of GDP in 2020).

But for once we would highlight a positive risk. Shall the PD-M5S government last and maintain an EU-friendly stance, then a virtuous cycle could emerge, with yields staying low and progressively reducing the debt-stabilising primary balance surplus. For instance, assuming yields stay at their present level for a year means that the primary balance required to stabilise debt drops to c. 1% of GDP. Assuming yields remain at their current level for five years implies that the debt-stabilising primary balance is actually around 0.

Market Sentiment

Improving Local Sentiment in a Global Yield-Grab

The bond markets’ reaction to political events in Italy has been very positive so far with Bund spreads hovering around 150 basis points (bp) – some 100bp tighter relative to Dec 2018 levels. In our understanding, this is the result of two key variables:

  1. Better chances of a constructive dialogue between Rome and Brussels going forward, in contrast to markets’ perception about the previous government coalition
  2. Global yield-grab. However, this variable was already supportive of non-core European government bond markets before this summer’s Italian political crisis, as we can see from Exhibit 10.

On the risk-side, however, fundamental factors still play an important role. If we aggregate both market and fundamental forces into an index[2], we get a clear idea of how Italy compares to its European peers in terms of systemic risk (Exhibit 11).

Contrary to previous episodes of sovereign risk, this time the risk is concentrated exclusively in Italy, while other issuers seem to enjoy a period of very subdued stress. Looking ahead, we would expect this indicator to improve in the near term, mainly driven by market-based variables – even though structural weakness is likely to persist, preventing a full normalisation of systemic stress in Italy.

 

Low Bond Yields versus Banks’ Profitability

Another interesting aspect of the current Italian government bond (BTP) rally is the divergence between bond yields and European banks’ equity valuations (Exhibit 12). The nexus between sovereigns and banks, initially introduced via Basel III’s “stealth quantitative easing”, has been observed in the past. In our view, the recent de-coupling highlights a persistent fragility in the European banking sector.

Despite a distinct reduction in overall sovereign risk, and the associated price returns to Italian banks in particular, investors are likely to discount a scenario of prolonged negative interest rates into financials’ prices. Furthermore, as we know from the literature on reversal interest rates[1], the positive effect of falling bond yields could be more than offset in the future by negative deposit rates.

Demand for BTPs…Waiting for Non-Residents

Unlike the demand for Spanish government bonds (Bonos), foreign demand for BTPs has not recovered in the aftermath of the sovereign crisis. The share of Italian sovereign risk held by international investors still hovers around 30%, in contrast to non-resident holdings of Bonos which have picked up from 35% in 2012 to 45% (Exhibit 13). Core issuers like France (52%)[4] and Germany (60%)[5] enjoy an even larger international participation in their respective sovereign markets.

We would attribute this lack of traction with non-residents to a vicious and persistent combination of political uncertainty and structural weakness. In addition, with the benefit of hindsight, the decision to avoid a “bad bank” solution in Italy may have exposed the banking sector to a lasting non-performing loan issue, which has reinforced the banks-sovereign nexus and – at the same time – introduced a source of financial fragility in the system.

We would not be surprised, however, to see a pick-up in foreign participation. A blend of risk/reward profile, carry profile (in particular around the two to two and a half year point, Exhibit 14), ongoing monetary policy support and global yield-grab might prove sufficient to attract international investors to a market that is deep, liquid and – as things look now – integrated into the European mainstream.

 

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[1] We use the debt accounting approach developed in Mauro, P. and Zilinsky, J., “Reducing Government debt ratios in an era of low growth”, Policy Brief, July 2016, PIIE

[2] Hollo/Kremer/LoDuca (2012), “CISS – A Composite Indicator of Systemic Stress in the Financial System”, ECB WP1426

[3] Brunnermeier/Koby (2018), “The Reversal Interest Rate”, NBER WP25406

[4] AFT website

[5] Bundesbank (2018), “The Market for Federal Securities: Holder Structure and the Main Drivers of Yield Movements”, Monthly Report July 2018

 

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