Hedgeye Virtual Portfolio: Short Italy (EWI); Long Germany (EWG)
Conclusion: We are seeing continued negative fundamentals in Italy’s economy and political risk heightening under Berlusconi’s fractured leadership. We shorted Italy via the etf EWI in the Hedgeye Virtual Portfolio on Sept. 24.
One of the first areas we focus on when sizing up an economy’s macroeconomic “health” is its debt and deficit levels (as a % of GDP). Across our research (in particular on the U.S., Greece, and Japan) we’ve noted the seminal work of economists Reinhart and Rogoff who show historically (across 800+ years) that countries reach a crisis zone of fiscal imbalance when their debt ratio is north of 90% and deficit ratio is greater than 10%.
With a debt ratio at 115.2% as of fiscal year 2009, Italy’s debt is of particular concern to us, while its deficit as a percentage of GDP is less worrisome at -5.3%, yet nevertheless above the -3% target rate set by the EU (see chart below).
This year we’ve been bullish from a top-down perspective on countries that issue austerity measures to clean up their fiscal houses. That said, fiscal trimming will not be a panacea across Europe to cure its ails. We see clear divergence among countries; we are bullish on Germany and continue to warn of further deterioration in the capital markets of countries like Portugal, Ireland, Italy, Greece, and Spain.
With regard to Italy we question the country’s ability to materially cut its bloated balance sheet on the backdrop of a much divided political landscape. Remember that back in July PM Silvio Berlusconi expelled his speaker of the Parliament, Gianfranco Fini, and other dissents from his People of the Liberty party, which left his party with a majority coalition. What lies now in the balance is the potential decision by Berlusconi to dissolve his government and set up a new administration or call for early elections next spring, three years ahead of schedule. In any case, we’d expect Berlusconi to choose the most politically expedient route for populous support going forward, which may not necessary equate to fiscal prudence.
Despite the issuance of €25 Billion in austerity earlier in the year, Berlusconi is up against a lofty €251 Billion of maturing debt next year (across all coupon types), according to Bloomberg data. As a point of reference, Germany, a country with an economy 1.6 times the size of Italy’s, has €210 due in 2011.
Already we’re seeing elevated signs of risk in Italian markets. In the charts below we show that Italy’s CDS spread, while well short of Greece’s 820 bps spread, has blown out to 206 bps. Also Italy’s 10YR spread over similarly maturing German bunds is kicking to the upside, as its equity market (Titan30) is broken across its TRADE (3 weeks or less) line of resistance and hovering near its TREND (3 months or more) resistance line—all bearish points. [YTD the Titan30 is down -11%.]
Today and tomorrow the Italian government will attempt to sell €9.5 Billion ($12.8 Billion) of bonds. As we’ve affectionately said numerous times: countries cannot continue to kick the can of debt down the road in perpetuity. Italy should be no exception.