Another Italian Drama – Why It Matters

Author: William Witherell, Ph.D., Post Date: October 3, 2018

Government deficit out of control, irresponsible government policies, tumbling bond prices and bank share prices, threat of rating-agency downgrades, political instability – we have seen similar Italian dramas in the past that, in the end, did not lead to serious financial market contagion. Nevertheless, there are reasons to be concerned that this time the impact could be more adverse for European and global markets.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

The populist coalition government of the anti-establishment Five Star Movement and the far-right League party, formed in late May, surprised markets last week by sharply increasing its government budget deficit targets for 2019–2022, including the Five Star election promise of a “citizenship income,” a form of universal basic income, and the League’s promise of tax cuts. The projected budget deficit of 2.4% of GDP for each of the next three years is three times the 0.8% deficit target for 2019 agreed with the European Commission last year, with improvements to 0.0% predicted for 2020 and a 0.2% surplus for 2021. The Italian government has to submit a draft budget to the European Commission no later than October 15. Tensions will likely increase between the European Commission and Italy over the fiscal measures included in this budget. Comments from the Commission already signal that they consider the draft budget to be incompatible with the stability and growth pact. Reactions of some of the eurosceptics within the government to the mounting pressure from Brussels are stoking market fears of increasing political strife.

A period of continued and possibly increased bond market volatility is looking increasingly likely. This could have negative effects on market liquidity and depth. The volatility limits many investors have on the assets in their portfolios would reduce market demand. Adding to this prospect, the European Central Bank (ECB) is expected to end its net asset purchases at year’s end. Since the beginning of this ECB program, the ECB has purchased 360 billion euros of Italian government bonds. The end of net purchases will coincide with a projected increase in the Italian government’s funding needs. That combination will lead to an increased supply of Italian bonds to the private sector.

It is unclear just how strongly the Commission will wish to pressure Italy because of that country’s backtracking on its commitment to structural fiscal consolidation; however, it is the market reaction that is of greatest concern to us. The Italian sovereign debt market is the third-largest sovereign debt market in the world. Developments in this market matter to both European and global markets. The government’s aggressive loosening of its fiscal stance, together with policies that are not growth-friendly, will increase concerns about the sustainability of Italy’s sovereign debt. Both Moody’s and S&P are expected to update their Italian debt ratings by the end of this month. Currently Moody’s rating for Italy is Baa2 (negative credit watch) and S&P’s rating is BBB (stable outlook). A rating downgrade would likely accentuate the reduction in bond prices that has occurred since last Friday. Calculations by Brown Brothers Harriman using current information imply that a rating of BBB- would be appropriate, a two-notch downgrade. BBB- is the minimum rating for bonds to be considered “investment grade.”

The 3.29% yield on the benchmark 10-year bonds at the closing on Monday, October 1, was the highest closing yield of the year – indeed, Italian bonds were at their weakest in four years. The closing spread over the German yield was 2.83 percentage points, which was not as great as the 3.25 percentage point reached during the summer following the emergence of the populist government. On Tuesday Italian bond prices continued to fall, with the yield rising another 10 basis points. The German-Italian spread increased further as German yields declined.

Wednesday Italian bonds recovered slightly, with the 10-year yield easing 6 basis points. The Italian government slightly revised their budget deficit estimates to -2.2% of GDP in 2020 and  – 2.0% in 2021. The basic situation remains the same and neither the European Commission nor the markets are likely to be moved. The good news is thus far there are no signs of contagion to other debt markets. Should that change, pressure on Brussels and on Italy would mount. The euro is under pressure from these developments, as well as difficulties in the Brexit negotiations, retracing some 50% of its recent rally.

The most immediate concerns about these developments relate to Italy’s banking sector. Declining values in the Italian bond market erode the balance sheets of Italian banks. At the end of last year Italian government bonds were reported to account for about 10% of Italian bank assets. In the second quarter of this year Italian banks increased their holdings of Italian government debt by more than 40 billion euros as foreign investors fled the market. Italian banks are thought to hold over $440 billion in Italian bonds. They are not the only banks at risk. French banks still hold some $319 billion in Italian bonds. German banks have reduced their holdings to $95 billion.

The Italian Economy Minister, Giovanni Tria, has argued that Italy will still be able to reduce debt over the next three years, as higher growth rates in those years would result from the government’s policies. Tria, a nonpolitical technocrat, is widely considered to be the adult in the inexperienced government. But he was unable to deter the populist government from the imprudent, expansive draft budget it released. As the budget has not yet been finalized, Tria may be able to achieve some final moderating changes, if the government becomes concerned about the risk of a crisis and a possible snap election.

Tria has sought to assure the European Commission that Italy will have more latitude going forward, pointing to his projections of a pickup in economic growth in the next several years. We do not find his forecasts convincing, particularly in view of the government’s reversal of some supply-side reforms. He forecast growth of 1.6% in 2019 and 1.7% in 2020. Growth was 1.6% in 2017. This year the economy looks likely to achieve no better than a 1% advance. Next year’s growth is forecast by the European Commission at only 1.1% and could well be less.

Italy’s economy grew at about a 1.0% rate in the first half of this year. According to Markit, the Italian economy appears to have stagnated in the third quarter. The manufacturing sector has weakened through the year with overall growth relying increasingly on a still strong service sector. Domestic demand is weak with depressed real incomes. Forward-looking indicators suggest very little growth in the fourth quarter.

Italy’s equity market has suffered from the above developments. The iShares MSCI Italy ETF, EWI, is down 5.60% over the five days through October 2, a period when Eurozone stocks, as measured by the iShares MSCI Eurozone ETF, EZU, fell 2.27% and the euro slipped 1.83%. Banks account for 30% of EWI’s weight, which means that this ETF is strongly affected by developments in Italy’s banking system and hence in Italy’s bond market. Italy’s banking stocks have suffered significant losses. At Cumberland Advisors we continue to be underweight the Eurozone in our International and Global portfolios, and we do not hold the Italy-specific ETF, EWI.

William Witherell, Ph.D.
Chief Global Economist
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