Last Thursday, the Italian government announced a budget deficit of 2.4% of the country’s GDP for the next three years, far above the 1.6% target from Finance Minister Giovani Tria. Even though the announced budget remains inside the 3% ceiling prescribed by the SGP, EU officials have been pressuring Italy to close the gap in order to work on its debt sustainability. Its current debt-to-GDP ratio stands at 130%, the second highest in the Euro area after Greece (with a ratio of 180%). The market reaction was imminent, with the 10Y soaring to 3.25%, its highest level since June. Figure 1 (right frame) shows the daily performance of Italian equities since 2014; the FTSE MIB index was down 4% on Friday, the sharpest drawdown since June 2016 (24th), the day after Brexit vote (the index was down almost 12%).
As our current leading economic and liquidity indicators are showing further weakness coming ahead in the Euro area, the political instability in addition to the uncertainty put the Italian officials in difficulty within the next 6 to 12 months. In this article, we raise some of the issues that Italy faces in the medium term.
1. Slowing economy and rising uncertainty
First of all, our leading economic indicator, which is built using a linear combination of surveys and price data, is showing further weakness in the Italian economic activity (figure 2, right frame). Italy is expected to print the second lowest growth rate among the ten biggest economies (after Japan) for the next two years; economists expected a real GDP growth of 1.3% and 1.1% for the year 2018 and 2019, respectively. We saw that industrial production contracted 1.3% YoY in July (according to Eikon Reuters), hence persistent weakness in fundamentals in the next 6 to 9 months could replunge the country in a state of crisis. One important indicator we like to look at as a MT potential driver of the dynamics of the debt ratio is the growth-to-interest-rate (GIR, real terms) differential. With a real growth rate of 1.2% in the second quarter of this year and a 10Y real interest rate of 1.74%, the GIR differential has been negative since April 2018 and currently stands at -54bps (we adjust the 10Y nominal by Italy HICP inflation rate to compute the 10Y real). Therefore, a persistent negative GIR differential will definitely challenge the Italian officials on the expected path of the budget deficit.
The 10Y spread against Spanish yield has widened dramatically since the beginning of the year, meaning that investors have looked at Italy as a separate case rather than withdrawing their capital from other peripheral countries (figure 3, left frame). Our concern earlier this year was that a sustained period of political instability in Italy could eventually lead to a contagion to the whole periphery, a scenario like we observed in 2012. In addition, the Economic Policy Uncertainty (EPU) index, a measure of economic and political uncertainty based on newspaper coverage frequency developed by Baker et al. (2016), has also been on the rise this year, co-moving strongly with the 10Y BTP yield (figure 3, right frame).
2. Low youth and elderly employment rate
With an employment rate of only 62.3% (20-64) in 2017, Italy is very far from the EU2020 national targets of 67%-69%. It has the second lowest level in the Euro area after Greece (57.8%) and stands far away from German employment rate of 79.2%. The economic and financial crisis has hit young people in particular; unemployment among those aged less than 25 ticked up to 31% in August, the third highest country after Greece (39.1%) and Spain (33.6%). More importantly, nearly 30% of the young population aged between 20 and 34 is Neither Employed nor in Education and Training (NEET* rate, figure 4, left chart). As a consequence, the productivity of the country has been flat for many years now and is not expected to pick up anytime soon if the current environment remains unchanged.
In addition, the employment rate among older workers stands at the low decile (such as France) relative to other advanced economies. For instance, the employment rate of those aged between 55-64 was of 53.9 in Q2 2018, compared to a weighted average of 61% for OECD countries and 71% for Germany, respectively (figure 4, right frame).
3. Elevated pension spending costs
The low employment rate in the youth workforce combined with the demographic trends are significantly increasing the cost on pension spending, hence weighing on the government’s budget. According to Eurostat, Italy’s total pension expenditure will stand at 17% of the country’s GDP in 2017, ranking second highest after Greece (18%). As for all other advanced economies, the largest expense item was old-age pensions, accounting for 12% of GDP. In addition, survivor pensions spending was the highest across all EU countries at 2.7% of GDP (figure 5, left frame). With the old-age dependency ratio expected to hit 60% within the next 20 years, pension spending could increase up to 22% of GDP by 2040.
Therefore, we strongly believe that the IMF projections of Italy’s debt-to-GDP ratio appear to be too optimistic. Figure 5 shows that the IMF expects the ratio to fall to 105% within the next 10 years on the back of significant primary balance surpluses. We are more aligned with the general consensus, which says that the ratio will stay around the current level within the next five years at least.
4. Consequences for asset prices
As we saw earlier, the sudden rise in political uncertainty in Italy has been negatively transmitted to asset prices, with the 10Y breaking above 3.3%, stocks experiencing sharp sell-offs (especially financials) and EURUSD down 2.5 figures and currently flirting with the low of its 1.15 – 1.17 range. As our leading economic indicator shows, we expect a slowdown in the Italian economy in the next 6 months to come.
Hence, the fall in excess liquidity, which is computed by the difference between real money M1 growth (adjusted by CPI) and the industrial production, will weigh on equities' performance in the medium term. Figure 6 (left frame) shows that the excess liquidity tends to lead equities' performance and especially the financials sector. We think that investors should decrease their exposure on the cyclical stocks and be more exposed to defensive sectors for the next months to come. In addition, a flattening yield curve could also weigh on banks performance, even though they currently appear cheap using a value approach.
Eventually, the euro (FXE) could also suffer in the short term if the spread between Italian and German bonds continue to widen. Even though the single currency is currently strongly undervalued against the greenback according to some fair value metrics, the BTP-Bund spread is usually a good driver of the currency pair in the short run.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.