Focus on Italy: macroeconomic and fixed income scenario

Which are your expectations for Italy? What about the government projections?

Italy is Europe’s initial epicentre of the current pandemic, with lockdown measures already in place in the first quarter. In a bottom-up assessment, we look at the sectors most severely hit by the lockdown, which represent around 40% of national output. Otherwise, we could consider the discretionary consumer spending put at risk or prevented by the lockdown, which accounts for almost 20% of consumer spending. Under such considerations, we put the cost of each week of lockdown at 0.8-1.5% of GDP. Based on our estimates and on Q1 GDP data recently released, we downgraded our GDP forecasts and now expect a contraction of about -8.0/-11.0% YoY for 2020. In 2020, the contraction will be deeper in the first half of the year, while in the second half we expect a strong rebound, although this will not be enough to make up for the GDP lost early in the year. The Italian government expects a deep contraction in the first half of 2020, at -5.5% and -10.5% in the first and second quarters, respectively, and a bounce back of 9.6% and 3.8% in the third and fourth quarters, respectively, with average yearly growth at ‑8.0%. For 2021 they project annual growth at 4.7%, which corresponds to a quarterly growth dynamic in line with potential at best. For 2021 we take into account the base effect which will play a significant role in lifting the year growth rate. We are cautious and forecast a 4.0% YoY rebound as a central case, driven by a quarterly dynamic gradually returning to potential.

What is the fallout on Italy’s public finances of the government’s scenario and its risks with regard to sustainability?

The government expects the stimulus measures to push the deficit-to-GDP ratio to 10.4% in 2020, with a primary deficit of 6.8% and a debt-to-GDP ratio at 155.7%, assuming GDP deflator at 1.0%). Yet, in case of deeper 2020 GDP contraction at -12.0% YoY, the deficit-to-GDP ratio would spike up to 13.0%, with a primary deficit above 9.0% and a debt-to-GDP ratio above 164%, that is, about 20 percentage points above its 2019 level. According to the government estimates, the economy will grow by 6.1% in nominal terms next year – or by 4.7% in real terms -- with a deficit-to-GDP ratio at 5.7%, allowing the debt-to-GDP ratio to decline to 152.7%.

So far, the government has not made any projections beyond 2021 in its “Economic and Financial Document” (DEF). Looking into 2022, we assume GDP growth to return to potential, together with some normalisation in the inflation pattern, at around 1.7% YoY. We could also see a return to a primary surplus of around 1.0%, with the deficit-to-GDP ratio below 3% and the debt-to-GDP ratio cut by an extra percentage point. This is a starting point for a long-term sustainability analysis. Under a simple rule of thumb, we assume that the combination of 2.4% nominal GDP growth, borrowing costs at 2.4% or lower, and a primary surplus of 1.0% will cut the debt-to-GDP ratio by around one percentage point per year.

Public debt issuance is set to grow considerably due to the remarkable deficit increase: what about the refinancing of debt maturing in 2020?

In the first four months of the year, the primary market for Italian public debt has seen an intense level of activity: the volume of gross and net supply placed has already reached around 47% and 75%, respectively, of the targets set for the entire year in the government’s January projections. In particular, the acceleration of primary market activity in recent weeks – which included the use of syndicated instruments with maturities of up to ten years -- raised around €33 billion in terms of net supply out of €45 billion projected for the entire year before the Covid-19 crisis.  The large share of long-term debt issues with maturities above ten years has helped keeping a long average life of the debt issued thus far, close to ten years compared with seven years for the entire stock of debt. To sum up, the Treasury’s aim is to keep overall borrowing costs as low as possible, while maintaining a long average maturity in order to reduce refinancing risks. In addition, a high percentage of the recent syndicated deals has been placed overseas, proving that yields have reached attractive levels. The progress made to date in terms of net proceeds will strengthen the role that the ECB has assumed with its asset purchase programmes in covering new and much larger issuance volumes, which will be added to those already planned over the coming months.

Turning to the rating agencies, we have seen different decisions by S&P and Fitch, which until a few days ago had the same rating and outlook for Italy’s public debt. What is your view on this, and on possible future developments?

The risk of Italian sovereign debt being downgraded in the short term was related mainly to a possible move by S&P and Fitch, both of which previously had an intermediate-level BBB rating, a notch above Moody’s (low BBB), and on a negative outlook, compared with stable outlook for Moody’s. While S&P kept its assessment unchanged in its recent review, in line with expectations, Fitch moved quickly and brought forward its review originally scheduled for July, cutting the rating by one notch -- to the same level as Moody’s -- and changing its outlook from negative to stable, also in line with Moody’.

We have noticed diverging rationales behind these choices: on one side, the macroeconomic assumptions of S&P and Moody’s converge towards a marked economic recovery in 2021, while Fitch expects a more limited rebound. Moreover, S&P and Moody’s stress – on one hand -- the central role of the ECB intervention in keeping borrowing costs under control, while, on the other hand, this role appears likely to be less crucial and more short-term oriented. Finally, the considerations over the potential European response and any use of existing instruments appear somewhat different. Following the latest Moody’s confirmation of both rating and outlook, we will not have any further news on rating for some months. The focus will turn to possible fiscal developments at the European level, to the next ECB moves and to the macroeconomic surveys reported in this period of crisis.

The proposal by France and Germany to launch of a ‘health sovereignty strategy’, together with the EU recovery fund and the authorisation for the EU Commission to borrow in the name of the EU, appears to be the sort of news that markets were looking with regard to further European integration. As in past occasions, Germany and France took the lead in taking further steps on the European front, pragmatically proposing a new solution to move forward from the current political impasse on developments regarding the recovery fund. The step looks to be a game-changer on the political front, as Germany had thus far remained close to the positions of northern countries -- recently staying mostly on the sidelines in the confrontation between the two prevailing groups of countries. This move also looks to be consistent with the statement released after the GCC ruling about the need for further integration and support for a stronger euro. The proposed amount (EUR 500Bn) for the Recovery Fund looks to be lower than numbers previously circulated in the press from different sources and players. This appears to be a better starting point to get dissenting countries on board with the initiative as well even if it is being portrayed as spending focused on hard-hit countries and sectors. The news was well received by the market, resulting in significant tightening of peripheral spreads, especially for Italy. This is likely to continue in the short term. Longer term, as often is the case with European politics, there are pros and cons. On the positive side:

• The Franco-German leadership is positive, and it is the first concrete sign of political willingness directed towards more fiscal integration.
• Initial issuance will come jointly from the two countries. Also, it is positive that those bonds will have long maturity.
• Following the powerful speech in the Bundestag by Angela Merkel and after the strong speech by the German president, Germany is clearly showing some commitment towards the Union.
• The collaboration sends a very strong signal to the most affected countries in the Union that solidarity is a founding pillar of the EU. This should also lead to fading momentum for nationalist parties.

On the negative side:

• The fund size appears small compared with what had been discussed previously (EUR 1Tn) and, as such, it will be insufficient to return Italy’s debt/GDP ratio to a sustainable level or to significantly support recovery in 2021.
• There has already been some pushback from the ‘Frugal four’ (Austria, Sweden, Denmark and the Netherland). This shows that implementation is likely to take some time, with a risk of the need to compromise vs the initial proposal.

Do you believe that the recent ruling by the German constitutional court (GCC) on the legality of the PSPP is relevant?

This is a complex legal issue, but we believe that the ruling is relevant as long as it could make it more difficult for the ECB to expand its PEPP programme if necessary. In particular, this ruling has confirmed the legality of the purchase programme that the ECB launched some time ago, affirming that the use of unconventional monetary policy instruments does not breach the ban on monetary financing of sovereign debt. At the same time, the court has given the ECB Governing Council three months to prove the appropriateness and proportionality of the operating procedures of the PSPP. The crux of the issue raised by the GCC seems to be not so much the choice of the instrument per se, but the methodology and size of the ECB intervention. The clarification that the ruling does not concern the more recent and substantial programme launched to contain the effects of the pandemic tempers the negative impact on the central bank’s room for manoeuvre as perceived by the markets. However, this ruling comes at a crucial time, when the ECB is pondering a possible increase and/or extension of the PEPP, which was launched in March when the economic projections were more upbeat than they are now, and could therefore weigh on the way the new programme is developed going forward. This ruling could introduce some scepticism over the future scope of monetary policy in a phase in which important developments are expected on the European fiscal policy, with the need for an effective mix of the two to fight the current emergency. BTPs could be harmed by the German constitutional court’s hints that the ECB purchases cannot be unlimited and must follow specific parameters:

• limited purchase volumes, stated in advance;
• 33% issue limit;
• compliance with the capital keys rule; and
• a floor for the credit quality of government bonds purchased.

Definitions

• Asset purchase programme: A type of monetary policy wherein central banks purchase securities from the market to increase money supply and encourage lending and investment.
• Basis points: One basis point is a unit of measure equal to one one-hundredth of one percentage point (0.01%).
• Bond ratings: If the ratings provided by Moody’s and S&P for a security differ, the higher of the two ratings is used. Bond ratings are ordered highest to lowest in a portfolio. Based on S&P measures: AAA (highest possible rating) through BBB are considered investment grade; BB or lower ratings are considered non-investment grade. Cash equivalents and some bonds may not be rated.
• PSPP: Public sector corporate programme.
• Quantitative easing (QE): QE is a monetary policy instrument used by central banks to stimulate the economy by buying financial assets from commercial banks and other financial institutions.
• Spread: The difference between two prices or interest rates.
• U-shaped recovery: A U-Shaped Recovery is a type of economic recession and recovery that resembles a U shape when charted.
• Volatility: A statistical measure of the dispersion of returns for a given security or market index. Usually, the higher the volatility, the riskier the security/market.