Recent economic evidence, combined with evidence from our meetings with Italian and European corporates, suggest the Italian economy is continuing to recover and the extent of this recovery is probably stronger than is being reflected in economic data. Anecdotal evidence from leading Italian CEOs note high levels of confidence, particularly in the north of Italy, strong export performance and a pick- up in business investment – these are all positive signals suggesting that the economic recovery is entrenched. Unemployment in Italy also continues to fall and tourism is booming, all of which points to improving consumer sentiment. So politics aside, we are positive on the prospects for Italy.
The economic outlook for the rest of Europe is also positive, notwithstanding some weaker survey data in Q1, which we attribute to weather and seasonal influenza impacts. Again reflecting our contact with corporates, what we see from Q1 earnings reports, bank lending surveys and the credit impulse are all suggestive of above trend economic growth. Consequently, all else being equal, we retain a positive outlook for continental European economies.
However, the recent political events in Italy are harder to calibrate as volatile politics are the norm in Italy and our discussions with Italian corporates lead us to believe that the recent political stalemate has not impacted Italian household sentiment; again anecdotal evidence suggests changes in consumer and investing behaviour in Italy emanating from political volatility are unlikely.
The newly formed Italian government might well be unstable (note: we are not expert in Italian politics) and could seek to introduce policies that are uncomfortable for both markets and policymakers elsewhere in Europe. That notwithstanding, we do not expect to see an extreme tail event emerge – such as “Italexit” or Eurozone exit – as has been suggested in the media. The economic benefits of Italian euro membership are evident in the competitive northern states of Italy, which are experiencing strong economic growth and where Italian wealth resides. This is shown in Chart 1 which shows the Italian Current Account position as a % of GDP. It is hard to claim that Italy is struggling to maintain euro currency membership when the country is running a trade surplus with the rest of the world.
It is clear that Italy did experience a deterioration in its trade position post euro entry, but the position has improved significantly in recent years perhaps suggesting that Italian businesses have adjusted to the rigor of Eurozone membership.
Chart 1: Italian current account as % of GDP
In addition, Italy is a nation of savers with a gross savings rate of 9.7% of GDP (the UK equivalent is 1.7%), a high stock of embedded savings and a high level of wealth. As such the costs of exiting the euro are simply far too high to envisage for Italian electors and is not economically rational. We also note that a Eurozone exit is not being sought by any of the large political parties in Italy and polls suggest it is not something desired by the population at large either. The age-old economic split in Italy between the north and south is, we believe, a bigger economic/ political issue than the status of Italy within the Eurozone itself and, as a euro exit would not solve this problem, we think it highly unlikely to occur.
We believe the key issues are really about the populist parties’ proposed tax giveaways and fiscal spending and, given the constraints within EU fiscal compacts, these will have to be watered down or negotiated as part of a larger adjustment in Eurozone fiscal rules.
As an aside we have some sympathy with the fight for greater fiscal autonomy within Italy and the view that the current fiscal compact is too restrictive, preventing much needed government investment in Eurozone countries including Germany. Moreover the Eurozone can operate a rules based system fiscal system (German preference) or a sovereign sharing approach (French preference) but if it is to be a rules based system the rules cannot be dictated by Germany alone. We have previously written about the ‘economic illiteracy’ of German policy making seeking to run a fiscal surplus when the household and business sectors are also running large surpluses; either Germany should stimulate domestic demand through more government spending or tax cuts or transfer the excess to other Eurozone members through Eurozone infrastructure initiatives.
The most significant Eurozone-wide impact from elevated sovereign bond spreads in Italy (vs. bunds), with modest contagion in Spain and Portugal, is that the ECB will most likely postpone any monetary tightening (particularly rate rises) further into the future as it seeks to entrench the economic recovery. This will likely lead to negative earnings revisions for Eurozone bank stocks but is not expected to impact other sectors. Overall, we do not expect the turbulence in Italian politics to impact economic sentiment in other countries and therefore do not see much impact on European equities outside of Italy and outside of the European banking sector. While we may experience several months of ‘noise’ we are confident that the positive outlook for European equities remains intact.