Positions in Europe: Short Italy (EWI); Short EUR-USD (FXE); Short UK (EWU)
Keep September 6th front and center on your European calendar. On this day, CGIL, the largest of Italy’s three main trade unions, is expected to strike against the budget cuts proposed in PM Silvio Berlusconi’s €45.5 Billion austerity package. We flag this date due to the associated volatility in European markets around the event, including follow-through implications for the package as Italy’s sovereign and banking health risks remain front and center.
We added Italy (via the eft EWI) to the short side in the Hedgeye Virtual Portfolio on 8/22.
Italy’s real issue is one of growth; critically, the terms of the austerity package could add further downside risks to growth as political risk under Mr. Bunga Bunga remains a clear and present danger.
The proposed terms of the austerity bill announced on August 12th include:
- Harmonized tax on financial income at 20%
- “Solidarity tax” of 5% on income earners over €90,000 and 10% above €150,000
- Spending by ministries cut by €6 Billion
- Requirement that towns of less than 1,000 inhabitants merge
- Scrap of 36 provincial authorities with fewer than 300K inhabitants
€20 Billion of the budget cuts are expected for 2012, with the remaining €25 Billion coming in 2013, to meet a promise Berlusconi made early in the month that Italy would have a balanced budget by the end of 2013. [Note: Italy’s budget deficit could shrink to 3.2% of GDP this year].
The new measures must be approved by Parliament within 60 days (from 8/12). Commentators suggest the package fails to address state-pension program reform, tax cheats, or labor reform, all of which may or may not be revised when it reaches Parliament next month. And Berlusconi is seemingly getting pushback on the package from all sides: his own center-right colleagues, the Northern League, the opposition and at least one main union, all of which bodes poorly for compromise on its terms, and ultimately its passage.
Based on structural constraints we believe that the country’s growth, and therefore revenue estimates, may be too lofty, which will undermine its ability to meet deficit reduction targets. In August, Finance Minister Giulio Tremonti said it’s sticking to government GDP forecasts of +1.3% and +1.5% in 2012 and 2013. But given the current economic environment across the region, and the fact that annual Italian GDP has averaged only +0.2% in the last 10 years, with a high of +2.7% in 2006, we think a GDP revision to the downside in 2012 and 2013 is highly probable.
And while one can argue that Italy is near the deficit limit of -3% (of GDP) set by the EU’s Growth and Stability Pact, we don’t see any country in the region immune to sovereign debt contagion risk. In particular, we’ve flagged the negative divergence in German equities and its slowing high-frequency data over the last 4+ months. And as we’ve seen over the last 18 month, countries that don’t meet their debt and deficit reduction targets have been punished severely by the market.
Another headwind that we’ve been vocal on is that the Italian Treasury faces €69 Billion in maturing debt (principal and interest) in September. This will create additional pressure on Italian issuance in the coming months. Since the ECB resumed its SMP bond purchasing program in early August to include Italian and Spanish paper, yields have come in, however Trichet has indicated that he has no desire for the program to either be large or take on a long duration. Instead, he promotes the EFSF as Europe’s debt “elixir”.
While Europe’s sovereign debt crisis has proven that policy change and market sentiment can shift with the wind, both the push back on the austerity and ultimately the terms of the program will be important to monitor to gauge capital market performance in Italy and across the region. Should Italy not be able to convince the market that it has its house in order, contagion, including into the heart of Europe, is going to get a lot louder, and swiftly.