Conclusion: Certainly, Italy isn’t Spain or Greece, but Italy does have a massive amount of debt, some €400 billion, that needs to be refinanced over the coming 12-months, which we believe is major pressure point for Italy.
Positions in Europe: Short EUR/USD (FXE)
With eyes focused on Spain’s recent €100B credit line to recapitalize its banks and investors digesting the results of the Greek elections over the weekend, we thought it important to contextualize the macroeconomic imbalances and risks in Italy. Italy has long been grouped squarely as a member of the PIIGS, and is a country we’ve persistently signaled as the largest potential risk threat in Europe, due in particular to the size of its economy, as the seventh largest global economy, the fourth largest in Europe, or the third largest in the Eurozone.
The main glaring risk threats that could propel Italy down the path to become Europe’s next domino is the size of country’s outstanding debt (at €1.9 Trillion or 120% of GDP); the mountain of debt it has to roll over in the next 12 months (nearly €400 Billion); and the market’s cracking credibility around PM Mario Monti’s ability to reduce the country’s fiscal footprint and spur growth.
Further, and as we show in the charts below, fear around Italy’s creditworthiness, which has recently been expressed by near cycle highs in sovereign CDS spreads and government yields on the 10YR, fall on some rather glaring negative fundamentals over recent quarters and years: declining GDP over the last three consecutive quarters; a rising unemployment rate (especially among its youth); deterioration in labor market competitiveness; and increased competition for export goods to its key trading partners. And while figures such as retail sales have held up relatively well (at least YTD compared to the Eurozone), we largely see the number supported by declines in the savings rate and the extreme growth in consumer credit, which we expect to revert to the mean; Service and Manufacturing PMI figures show a decidedly negative trend and we don't see the underperformance versus the Eurozone aggregate materially rebounding over the intermediate to longer term. We also expect FDI to roll over in step with this contraction.
Specific to risk signals, Italy’s 10 year yield remains elevated around 6%, with 5 year CDS trading at 546bps, or just under Spain’s CDS at 614bps. We believe all this spells increased pressure on the Italian economy to grow over the next 3-5 years. Not only will Italy, like all EU members, see spillover effects from economic weakness throughout the region—as most countries main trading partners are fellow EU members—but the higher cost to service its debt will put more pressure on politicians to raise taxes to meet funding requirements, all of which will put further downside pressures on the overall economy. And this comes at a time in which Monti’s credibility in parliament is shaking and foot power (strikes and riots) remains strong across a populous that is largely against austerity.
One savings grace to keep in mind when assessing Italy is that its public deficit stands at -3.9% of GDP as of last year compared to Spain’s at -8.9%. Italy may in fact be compliant with the Growth and Stability Pact limit of -3% by 2013, yet we think the road will be challenged. When one combines the challenges of issuing austerity, the higher cost to service debt, and the spillover effects from struggling peer economies with a tighter credit environment, Italy is likely to shoot below its growth forecasts this year and next, while heightened default fears may call Eurocrats to act on a bailout that is greater than the capabilities of the existing bailout facilities. As we discuss in our conclusion, Eurobonds may be the only viable solution should the market’s fear of Italy’s sovereign and banking risks reach a precipice.
By the Charts:
We think contextualizing the macroeconomic imbalances and risks in Italy can best be expressed through charts and select commentary:
Debt’s Drag - We begin by looking at Italy’s debt profile. At 120% (as a % of GDP) –the second highest in Europe behind Greece—its debt servicing load will equate to €400 Billion over the next 12 months alone.
Growth Slowing - As the data from Reinhart and Rogoff shows, when a country’s sovereign debt load exceeds 90% (of GDP) growth is dramatically impaired. We think the market will continue to punish Italy via higher servicing costs, and we do not expect the 10 year yield to dip materially below its current level of 6% over the intermediate term. Italy has already seen three consecutive quarters of negative GDP. Over the last 10 years on an annualized basis, GDP has averaged 2%. We see Italy undershooting IMF growth forecasts of -1.8% in 2012 and -0.3% in 2013.
Debt Maturities High - Italy has an extremely aggressive debt schedule to roll over in the next 12 months. The remaining 2012 debt due (Principal + interest) = 70% of GDP. This compares to 49% for France; 45% for Spain; 23% for Germany in the remainder of 2012. On June 14th Italy sold its max target of €4.5 billion of 3-7-8 year bonds, however the 3 year averaged a yield of 5.3% vs 3.91% on May 14th, or a 36% premium in one month! We’d expect a similar trend of filling demand through higher yields into year-end should we not see any “bazooka” from Eurocrats.
Too Big to Fail? - The answer to this question is unequivocally YES under the present bailout facilities. If we consider Italy’s outstanding debt and tack on another €272.7 Billion of borrowing from the ECB (chart below)—without even mentioning the potential bailout needs for Italian lenders crippled with sovereign holdings—it’s apparent that the remaining funds of the EFSF (around €200 Billion) plus the €500 Billion from the ESM that is expected to come online on July 1, 2012 (assuming, in particular that Germany’s Parliament signs off on it on June 29th), is undercapitalized to handle an Italian bailout, and fallout across the region from the failure Italy. [EFSF guarantees: Germany 29.07%; France 21.83%; Italy 19.18%; Spain 12.75%]
Deficit Dual – Italy’s deficit stands at -3.9% of GDP as of 2011. This rate, compared to Spain’s -8.9%; Ireland’s -13.1%; Portugal’s -4.2%, and may be the country’s a saving grace.
Fiscal Consolidation – However, Italy’s path forward on fiscal consolidation has been anything but clear and orderly. The corruption and standstill of the Berlusconi government was obvious; yet the technocrat government of PM Mario Monti is also marked by disunion. For one, while Monti has promised the market big fiscal cuts, they’ve yet to all be ratified by the Italian Parliament. Below we present the web of promises. On June 15th the Italian government moved forward with a package worth €80 Billion to spur economic growth, including selling states assets and reducing public spending.
Risky Profile - Italy is showing a similar risk profile to Spain. Here we chart the spread over German bunds.
Underperforming Growth - A major leading indicator for growth is derived from PMI surveys. As the two charts below indicate, Manufacturing and Services PMIs are well under the Eurozone averages and have been under the 50 line that divides expansion (above) and contraction (below) for more than 10 and 12 straight months, respectively.
Labor Cost Inefficiencies - A major factor behind Italy’s slower growth profile is stagnation in its productivity, witnessed by higher unit labor casts, while wages, despite declines, have yet to turn negative.
Industrial Production –Slowing and underperforming continued. In a recent European Commission paper reviewing Italy, the report noted that stagnation in production is the key factor behind Italy’s loss of cost competitiveness since the euro adoption.
Trade Balance Improvement – On a positive note, since early 2011 Italy has become less and less of a net importer.
Exports Mismatch – However, export growth has also slowed, providing less of a benefit to the top line.
Export Breakdown – Italy has high specialization in textiles, clothing, metal, and minerals, but due to the relatively small size of Italian firms, Italian exports to its main EU trading partners have found increased competition over the last decade. Further, its increased share in non-EU countries (particularly Eastern Asia) has yet to reap full benefit. [Main export partners: Germany = 13.1%; France = 11.6%; Spain = 5.3%]
New car registrations - Yet another metric we follow. Here again, no surprise, underperformance vs the EU average.
Smashed Piggy Banks - The Italian household savings rate moved from a high of 17.8% in mid 2002 down to 11.6% as of Q3 2011. The chart shows that Italians leveraged their savings in the upturn and in the downturn. The tapping of savings in the last three years demonstrates to pay off debt and the resilience of the Italian consumer to maintain previous spending levels.
Consumer Credit Drying Up – As the pace of consumer credit has slowed, retail sales have still remained resilient, especially in the year-to-date period. Here Italy has shown a positive divergence over the Eurozone since the start of the year based on a 3 month average compared to the previous year. We chalk this up the sticky levels of consumer credit, and continued draining on savings.
Unemployment Hooking - Another grave dynamic is the underemployment across Italian youths at 39%. While short of the 50.2% for Spanish youth, combine “a lost generation” with Italy’s demographic headwinds of an aging population (near oldest in Europe) and you have a cocktail that puts great pressure on social services, and the debt and deficit loads in the years ahead.
Square Stagflation - While we expect inflation to moderate into the back half of 2012, sticky stagflation (and negative real yields) has been a theme across much of the globe as energy prices remain elevated in the weak dollar environment.
Risk Lines in the Sand - From a risk perspective, we turn to both government yields and CDS spreads. Both are tracking hockey stick moves.
Spreads Pressure Banks - Finally, we show that Italy’s 10s-2s spread is not helping the banks and is another indication of the dampened growth outlook by investors. We’ve shown the timing of the two 3 month LTROS, in December ’11 and February ’12, respectively as reference points. Interestingly, while the first LTRO gave a boost to the spread, the market to a negative reaction the increased liquidity from the 2nd LTRO, as the insolvency of banks became the focus and it was not clear that “the injection” was actually being circulated throughout the economy, witnessed by extremely high levels of euros being parked at the ECB’s overnight deposit facility.
It’s no great secret that risk has shifted quite precipitously from peripheral to peripheral over the course of the last two years (with the longest stay in Greece) in what has been called Europe’s sovereign debt and banking crisis. However, when we discuss the bailout needs of Italy, the largest economy of the PIIGS, we’re talking about risks (disruptions) to continental and global economies that inevitably lead one to the question: Is Italy too big to bail?
Over the last years we’ve seen Eurocrats, under the support of Troika, coming to aid the sovereigns at every step: Greece, Ireland, Portugal, and now Spain. Unfortunately, we think Italy is far too large to rescue. In short, we believe the only way out over the intermediate term is the issuance of Eurobonds, a position the Germans are against, and rightfully so in our eyes for they do not wish to take on Italy’s credit risk.
After all, why would a German give an Italian use of his credit card carte blanche?
Clearly, Europe’s back is against a wall, as member countries are unlikely to post more capital upfront for bailout facilities (and here the IMF may have to take on a much larger role outside of its mandate). But what we fear, and the market may not understand, is that there is no “bazooka”, no panacea, to cure Europe’s collective sovereign and banking risks in one shot. Surely, the threat of an Italian default leads us down a road of even higher uncertainty on Europe’s go-forward, all of which portends that the downside in European capital markets is not fully priced in.
Could the next two years look like the last two years? We think the answer could be a qualified yes, however making such calls is reckless given that the direction of Europe changes on a nearly daily basis. For now, the fate of Italy, along with the rest of Europe, will be wrapped in the hands of Eurocrats. The main topics on the table include: a Fiscal Compact; a Pan-European Deposit Insurance; Eurobonds; a European Redemption Fund; the terms of passage of the ESM (and EFSF); and a European Financial Transactions Tax. There’s obviously a lot on the table; we do believe that Eurocrats wish to maintain the exiting Eurozone fabric. We’ll be monitoring the developments at the Eurogroup and EcoFin meeting on June 20-21 and the EU Summit in Brussels on June 28-29 to take our cues.