The Italian equity market fell almost 4%, and 10-year Italian government bonds dropped, with yields increasing by 26 bps to 3.14% on Friday, September 28. These moves were in reaction to the proposed 2019 budget which promised a sharp increase in public spending, cut taxes and roll back unpopular pension reform. The 2019 budget aims for a deficit of 2.4% of GDP, much higher than the 1.6% target for the year set by the previous government.
The higher deficit target increases the risk of rating cuts for Italian sovereign debt. Currently, the ratings are two notches above junk, reflecting the country’s 2.3tn euro debt, the third highest in the world. Italy’s debt-to-GDP ratio is 130%. A large chunk of Italian government debt is owned by local banks which got hit hard as the value of their holdings dropped. Italian banks have been impacted by weak profitability and non-performing loans due to recessions in 2011-2013, and near-recessionary conditions in 2014. This is the sovereign-bank “doom loop” where high government debt hurts banks who own it, and in turn, depresses lending which leads to further economic weakness and increased government debt. Even the recovery since 2015 has been weak, with GDP growth hovering between 1% – 1.6% over the last three years.
The March 2018 election resulted in a hung parliament with no party winning an outright majority. After three months of negotiations, a coalition between the populist Five Star Movement and the League led to the formation of a government in June. Markets displeasure at these developments was reflected in Italy’s equity market dropping by 10% relative to global equities, and the 5 year CDS spreads widening from 89 bps to 249 bps between April and May of 2018. Italian equities have dropped another 10% between May and September 2018.
The markets have sent a strong signal to the defiant coalition government that fiscal profligacy amid a 130% debt-to-GDP ratio is not tenable. At this rate, the markets will likely undo any boost the economy would have received from higher government spending in 2019 through higher borrowing costs, weakened banks which will not be able to boost lending, and a weakened equity market. This is before any reprimand from the EU which could lead to further instability.
Italy has been flagged as a value trap since the end of June 2018 in our country allocation framework. The market appears to be inexpensive, but its growth, risk, momentum and monetary policy indicators are extremely weak. The markets are on notice that the two populist Deputy Prime Ministers are likely to pursue a loose fiscal policy which puts them at odds with broad EU guidelines. This will not help the highly indebted economy and might set the stage for continued market volatility.
Italian Equities Relative to Global Equities
Italian equities have lagged global equities since early May