Markets have mostly rebounded after last week’s political uncertainty
Following electoral wins in both houses of the Italian Parliament in March, M5S and LN negotiated for three months to reconcile their divergent priorities and form a coalition government. After initially vetoing the new coalition just days before (due to the appointment of the Eurosceptic Paolo Savona as Finance Minister), on 31 May President Sergio Mattarella approved the new government with the following key individuals:
The political uncertainty after Mattarella rejected the government shook markets globally but the reaction reversed as investors found relief in the appointment of a more moderate finance minister and the receding likelihood of new elections, as shown in the following charts.
Chart 1: Spread on 2-year Italian BTPs versus German Bunds (%)
Chart 2: Equities (rebased to 100 at 1.5.2018)
Chart 3: EUR against other currencies
Source: Bloomberg, Unigestion calculations, as at 6 June 2018
Although the spread on Italian Buoni del Tesoro Poliennalis (BTPs) vs Bunds remains somewhat elevated, equities have recovered their losses from the end of the month and the euro has bounced back. While these moves suggest investors believe the situation has stabilised, we have concerns about the economy in Italy and, more broadly, Europe.
Most scenarios don’t look good for financial assets
In our view, there are a few scenarios that are likely to transpire, listed below in ascending order of worry:
- Grudgingly falling in line: The coalition waters down its proposals significantly and relations with Brussels are tense but not fractured (best case for investors);
- Runaway debt: Key fiscal proposals are implemented leading to a rise in public debt and tensions with Brussels become fraught, but haircuts on public debt or a referendum on the euro are explicitly dismissed;
- Coalition implosion: The government fails to get key proposals through Parliament, Conte is unable to reconcile the two wings of the coalition which collapses, and new elections are called for, which itself is seen as a referendum on the euro;
- Euro under fire: Key fiscal proposals are implemented, along with haircuts on public debt, and relations with Brussels deteriorate to the point that the parties jointly call for a referendum on the euro.
Assigning probabilities to each of these events is very difficult, but our base case is scenario 2: the new government delivers on most of its promises but avoids open conflict with the EU and its debt holders. But we should be clear, given how fluid the situation is, any of these outcomes transpiring would not surprise us.
The coalition’s fiscal policy will likely put Italy’s nascent recovery at risk
Italy has struggled for years to recover from the GFC, and only started to see its economy turning in the last few years on the back of the European Central Bank’s (ECB) quantitative easing programme. If we look at the level of the economy, real GDP is still 5% below its pre-GFC peak and industrial production is nearly 20% below. Unemployment remains elevated at around 11% (versus c.6.5% in 2008), with about 32% of young Italians without jobs (versus c.22% in 2008). Public sector debt is about 130% of GDP according to the International Monetary Fund (IMF), well above the European Union’s 60% Maastricht limit. But in change terms, we can see the beginnings of a recovery: starting from mid-2015, nominal growth exceeded the nominal interest rate for the first time since 2008, leading to a deleveraging wherein the Italian economy can continue growing. Real GDP growth turned positive around the same time and has steadily risen to 1.4% year-on-year today. While still below the 2008 peak, Italian real GDP and industrial production are back to their 2011 levels, before the onset of the Eurozone sovereign debt crisis. Unemployment peaked at around 12.5% in 2013 and is slowly grinding down, with youth unemployment peaking at the same time at around 45% and similarly declining. Public debt has plateaued since 2015 and the IMF projects it to fall by 2% of GDP per year for the next six years. Our growth Nowcaster points to consumption, employment, housing and investments all applying pressure on economic growth to exceed potential.
Chart 4: Real GDP and Industrial Production, chart 5: Real Private Consumption and Investments
Chart 6: Unemployment Rate, chart 7: Growth and Interest Rate Differential Driving Debt
Source: Bloomberg, IMF, Unigestion calculations, as at 6 June 2018
But change has not come fast enough for many Italians, and the M5S and LN coalition aims to deliver a fiscal policy they believe will hasten the economic recovery. Key provisions include a universal basic income for unemployed and low-income people, cutting taxes and simplifying the Italian tax code, and lowering the retirement age by scrapping the 2011 pension reform. We understand this would cost about EUR 110 billion, or 6.5% of 2017 GDP, financed according to the government by a resulting surge in growth. Though fiscal expansions typically boost growth, they also naturally raise yields on government debt to the tune of about 25 basis points for each 1% of additional expenditure/GDP by our estimates. With Italy’s already high level of public debt, swirling questions about their commitments to repay their debts in full and some coalition members mentioning debt redenomination, we would expect investors to demand an even higher premium from BTPs. The likely rise in yields would have three important impacts that would constrain demand:
- credit creation would fall as the cost of credit across the economy rose;
- debt service costs would rise as existing debts were rolled at higher interest rates; and
- Italian asset prices would fall mechanically as the discount rate rises, leading to a negative wealth effect for holders of these assets.
Even if the proposed policies offset an interest-rate-driven contraction in demand, the boost to economic growth looks to be limited while the impact on Italy’s public debt would be quite severe. For instance, we estimate that the fiscal expansion would at most lift real growth from 1.4% today to c.2.4% by 2021, but would shift the nation from a path of debt reduction to debt expansion, which we project to hit 133% by 2021 under this scenario. Such a debt expansion would have serious consequences for the creditworthiness of Italy’s sovereign debt, its banking system and perceptions of its commitment to the euro.
Chart 8: Projected Gross Government Debt % GDP
Source: IMF, Unigestion calculations, as at 6 June 2018
Key risks include the banking sector, Italian equities, and BTPs
After high-profile bailouts and the burgeoning recovery, Italian banks are relatively healthy: their aggregate solvency and liquidity ratios are comfortably above the Basel III requirements, non-performing loans (NPLs) are high but have been declining since 2015 and we have not seen any signs of depositors pulling their money for fear of a bank failure or euro exit. But there are causes for concern, chief among them a recurring theme of the European debt crisis. Local banks hold a large stock of domestic sovereign debt and are thus at risk if there is a sharp rise in government yields, say from a large fiscal expansion. According to a recent BIS report, 18% of Italian banks’ assets are domestic government debt, the largest holdings of any developed world banking system (Spain and Japan are next at 14% each). The Bank of Italy, in their recent Financial Stability Report, also anecdotally remarked that “less significant banks” (i.e., banks not supervised directly by the ECB) hold a larger proportion of their assets in domestic public sector debt than the banking system as a whole. This suggests to us that there are pockets of risk in the Italian banking system that may be masked in the aggregate. Even if solvency and liquidity ratios for individual Italian banks can withstand a sovereign debt downgrade and any ensuing equity devaluation, the subsequent pressure on their balance sheets would likely lead to a tightening of credit conditions, constraining demand at a critical time.
Chart 9: Solvency Ratios, Chart 10: Liquid Assets to Short-Term Liabilities
Chart 11: NPLs Net of Provisions (%GDP), Chart 12: Bank Claims on Local Govt Debt (%assets)
Source: Bloomberg, BIS, Unigestion calculations, as at 6 June 2018
Beyond the banking sector, the impact of the new coalition on Italian equities and bonds seems likely to be negative, or at least uncertain. In our view, returns will largely be driven by mercurial political forces and less by fundamentals, which for now are improving but look to be at risk under the new government. The roughly 25% weight on Italian banks will be a drag for the FTSE MIB, and we have already discussed the upward pressure on BTP yields. Moreover, Italian firms draw much more of their revenue from the rest of Europe than European firms draw from Italy, suggesting that in the tail scenario of a euro exit, Italian firms would suffer more from resulting trade frictions.
Chart 13: Revenues of Firms by Region
Source: Citigroup, Unigestion calculations, as at 6 June 2018
As a result of these risks, we have only a minimal exposure to Italian assets in our multi-asset funds, and have completely removed them from our European and World equity portfolios.
Monetary policy is not the cure for Europe’s ills
At this point, it seems clear to us that Europe has not shaken off the risk of nationalist and anti-establishment political parties rising to power and challenging the status quo. Along with Italy, recent elections in Austria, Hungary, and Slovenia have shown that Macron’s victory last year was the exception to the rule. It is also clear to us that monetary policy is not the cure to Europe’s existential crises. Indeed, we do not believe the ECB will respond to these brewing risks by altering their policy stance unless there is a severe market reaction, banking crisis or significant possibility of euro-wide deflation. Acting without a clear systemic risk would raise the issue of a moral hazard, and comments from ECB members suggest they view the situation in Italy as one the new government itself must confront. Rather, in order for the European Monetary Union to successfully rise to these political challenges, it needs reform aimed at building a fiscal union with risk sharing across nations. Achieving this is a daunting task with a myriad of obstacles, but if European nations want to stand as a nexus of global power alongside the likes of the US, China, and other economic heavyweights, they must stand together, arms linked.
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