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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.
Conclusion: All joking aside, while the CBO shows a narrowing of the U.S. budget deficit over the coming years, its projections are predicated on a highly optimistic growth scenario.
The Congressional Budget Office came out with their revised economic and deficit projections this morning and they were interesting to say the least. Perhaps the most noteworthy components, or potentially least reliable, were the economic assumptions in the CBO’s projections. Our Healthcare Team did an excellent point grinding through the release in real time this morning. As noted, the key red flag from the CBO’s numbers are the economic projections, specifically GDP growth.
The CBO’s GDP growth estimate for 2011 remains at 2.3%, which is going to be well off the mark, and then accelerates to 2.7% GDP growth in 2012. Interestingly, the CBO’s growth forecast then hockey sticks to 3.6% from 2013 to 2016. Based on the most recent data we’ve analyzed, these projections are highly optimistic to say the least, given the structural constraints facing the U.S. economy.
For comparative purposes, over the last ten years, starting with the most recent quarter, the U.S. economy has grown at an average real GDP growth rate of 1.6%. If we extend back twenty years, the United States has grown on average at 2.6%. So, while it is possible that the next five or so years will see an acceleration, it is somewhat unrealistic given the many headwinds still facing the economy.
The primary issue with being substantially off on GDP growth assumptions is that it really informs the remainders of the projections, namely long term debts and deficits. The CBO, after also incorporating assumptions from the recent debt deal, now projects U.S. deficits to narrow over the coming years from an estimated -$1.3 trillion in 2011, to -$973 billion in 2012, to -$623 billion in 2013, and to -$380 billion in 2014. That’s actually a decent narrowing of the deficit, but, of course, it assumes the optimistic growth assumptions above.
The key impact high GDP growth has on the federal government budget is on government revenue growth (more commonly known as tax revenue). In the CBO’s estimates out today, government revenue grows at 8% per year over the next decade. While part of this growth is driven by an expiration of the Bush Tax cuts at the end of 2012 (although that is questionable in the scenario that Obama loses), much of it is supported by economic growth and employing reverting to historical averages.
The CBO actually provides a perspective of the deficit outlook in a slower growth scenario. According to their models, if real GDP growth was 0.1% lower per year, then the cumulative deficit through 2021 would be roughly $310 billion larger. In the realistic scenario in which GDP growth is a full percent lower than the CBO predicts over the next ten years, that is a $3.1 trillion addition to the cumulative budget.
Historically, the CBO has been very inaccurate in projecting the deficit beyond the very short term. In August 2009, which was exactly two years ago, the CBO was projecting a deficit for 2011 of $921BN. The actual deficit for 2011 will be ~$1.3 trillion, or more than 40% higher than they projected just two years ago. In addition, the projected deficit for 2012 back in August 2009 was -$590 billion. The CBO is now projecting a deficit of -$973 billion for 2012, which is 56% more than their estimates from just two years ago.
We would strongly urge caution in reading too much into the projections of the CBO. Historically, they have proven to be way off the mark and continue to incorporate economic projections that do not reflect reality. The greater concern is that Congress takes the CBO’s projections seriously and underestimates the magnitude of debt and deficits challenges facing the Federal Government. If we’ve learned anything from Europe YTD, it’s that there’s an eventual end to the road on which the proverbial “can” is kicked.
Daryl G. Jones
Director of Research
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