Adding Italy To The Short Side
Summary
- Italy's government debt to GDP is too high.
- Italy's government expenditures equal 50% of GDP, an unhealthy reliance on government outlays.
- The economy is leveraged to the banking sector which is falling apart.
Italy (NYSEARCA:EWI)
As a strong believer in the theory of debt deflation and the tremendous negative consequences that arise from excessive debt, high debt sectors and countries tend to make the top of my short list.
I have written at length on the theory of debt deflation and why an economy based on debt has slower growth, low inflation and lower long-term interest rates, a dynamic that is bad for overall prosperity and enables greater wealth dispersion.
When looking at the major developed countries of the world, Italy (EWI) ranks near the top in terms of government indebtedness. Italy's debt currently sits at 132% of Gross Domestic Product, or total output for the country.
Government Debt to GDP:
Source: Trading Economics, EPB Macro Research
Italy clearly has a debt problem and the ideal solution would be to reduce spending and lower the county's indebtedness, allowing for more economic prosperity. The problem Italy finds itself in is the heavy reliance on government spending to fuel the economy. Italy ranks second among developed countries for government spending as a % of GDP.
Government Spending as a % of GDP:
Source: Trading Economics, EPB Macro Research
Italy has a debt problem and needs to reduce spending. The government spending is currently 50% of GDP and a reduction in expenditures would massive slow GDP growth in Italy. The country is very reliant on government spending and needs to reduce expenditures.
Italy has two choices. They can continue to increase government expenditures and increase their indebtedness, risking default or a banking crisis, or they can reduce government spending which would massively hurt GDP growth in the short run given the % of the economy tied to the government.
Either path has massive drawbacks and the rise of political instability in Italy is not a surprise given the two very distinct options the country faces.
The recent election is only the beginning of the instability that will come from a major choice in the country's history as to what to do in regards to their debts. The banking sector in Italy, which makes up 35% of their stock market, another great reason to have Italy on the short side, has a massive non-performing loan issue. The Italian banks are fragile at best and insolvent at worst. They cannot handle another economic downturn at the level of current indebtedness.
The problem is that just what Italy cannot handle, an economic slowdown, is exactly what is occurring. Again, not a surprise that the elections have had some surprising results.
Below is a chart of the quarterly GDP growth rate in Italy. As the chart shows, there was a very clear and meaningful acceleration in growth for most of 2017. Italian equities (EWI) increased dramatically on the back of this acceleration in growth. The growth, however, has now rolled over and is decelerating back down the level of growth seen in 1Q2016.
Italy Quarterly GDP Growth:
Source: Trading Economics, EPB Macro Research
The trend in retail sales growth in Italy also confirms the rise in growth for 2017 and the subsequent decline heading into 2018.
Italy Retail Sales Year over Year:
Source: Trading Economics, EPB Macro Research
While the story of Europe accelerating was the call for 2017 and may pundits advocated allocating capital to Europe over the United States, I believe that 'Europe slowing' will end up being the consensus call for 2018.
Italy has one of the worst demographic situations in Europe (and the world), as well as massive debts, and extremely heavy reliance on government spending. The current slow down that we are just starting to see in Europe will impact Italy (EWI), likely the worst due to the present conditions.
The slow down in Italy has the potential to shake the political situation, which we seem to be already witnessing, test the solvency of the banking sector, and challenge the ability of the country to repay their debt or remain in the European Union.
There is a growing push for Italy to exit the European Union which would be entirely consistent with rising social unrest due to the current path of the country which had led to major fiscal issues.
Over the next 1-2 years, the expected holding period for this short, Italy (EWI) could fall over 30%, depending on the impact to the baking sector. The Italian banks can already be deemed insolvent and if a slowdown makes that situation worse, there could be massive declines in the Italian stock market, which is heavily leveraged to banks, making up 35% of the total market.
This article was written by
Eric Basmajian is the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices. He was previously an analyst at a quantitative hedge fund.
Eric leads the investing group EPB Macro Research where he applies investing strategies with the understanding that when there is an economic inflection point, company fundamentals don’t matter, technical trends break down and investors are blindsided. His analysis helps investors position their portfolios to avoid losses and maximize gains during changing economic conditions. Learn More.
Analyst’s Disclosure: I am/we are short EWI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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