Investment Research General Market Conditions 12 August 2014 Periphery research: Ireland Virtuous cycles supported by credit rating upgrades The strong Irish growth performance was confirmed in Q1 and forward looking, indicators suggest that activity remained strong during Q2. This implies we expect GDP growth to be 4% in 2014, which will be the strongest rate since 2007. The economic progress has followed as Ireland has made significant structural adjustments, which should imply it will be able to continue on a more sustainable growth trajectory going forward. The improved macro economic situation has also resulted in a stabilisation in the debt ratio. The forecast is for a declining trend, but the improved fiscal situation could result in a faster decline than currently anticipated. The better economic situation should also continue to support credit rating upgrades, which in turn will lead to lower sovereign yields. In that way, it should result in a virtuous cycle where debt declines further. On Friday, Fitch has Ireland up for review and we expect the sovereign credit rating to be upgraded to single-a rating. Another single-a rating (in addition to S&P) would, in our view, have a positive impact on the Irish market. This should follow as it should result in more investors being able to buy Irish government debt. The other four periphery countries are also considered and even though some of them still have increasing GDP ratios, they have started to benefit from credit rating upgrades. Periphery research Spain: higher domestic demand and improved competitiveness, 11 August Ireland: virtuous cycles supported by credit rating upgrades 12 August Portugal: pent-up demand to boost economic activity 13 August Italy: new political agenda and support from the ECB 14 August Greece: signs of improvement compared to the recovery in Latvia 15 August Virtuous cycles supported by credit rating upgrades Source: Fitch, Moody s, S&P and Danske Bank Markets Senior Analyst Anders Møller Lumholtz +45 45 12 84 98 andjrg@danskebank.dk Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Important disclosures and certifications are contained from page 8 of this report. www.danskeresearch.com
Rebound in growth The strong growth performance in Ireland continued in Q1 when GDP growth increased 2.7% q/q. The jump was mainly driven by increasing net exports but domestic demand also made a positive contribution as both private consumption and gross fixed capital formation increased in year-on-year terms. Together with the release of the Q1 figure, the dreadful Q4 13 print was revised up from -2.3% q/q to -0.1% q/q, which suggests a very strong 2014 GDP print. We forecast 2014 GDP growth of 4.0%, which will be the highest growth rate since 2007. Our projection of strong growth during 2014 is supported by leading indicators, which suggest that growth remained strong during Q2 and at the beginning of Q3. The Irish composite PMI figure was 60.2 in July and new orders also remained above 60, implying it is still around the peaks in 2000 and 2006 and that it points to a yearly growth rate close to 5%. Leading indicators suggest that growth remains strong Consumer confidence has improved significantly Source: Markit PMI, Central Statistics Office Ireland Source: European Commission, Eurostat Consumer confidence has jumped and signals private consumption will contribute to activity in 2014, after it has overall been a drag for the past three years. The improvement in confidence has followed as unemployment has declined, implying that consumer unemployment expectations are around the lowest level since the beginning of 2001. In addition, it has been supported by a continued recovery in house prices with the June print up by 12.5% y/y. Consumers expectations about purchasing or building a home within the next 12 months have increased sharply and in Q2 14 it was at the highest level since 2007. Retail sales trend upwards and car sales have surged Industrial production above the level from the boom in 2005 Source: Central Statistics Office of Ireland Source: Central Statistics Office of Ireland 2 12 August 2014 www.danskeresearch.com
The improvement in consumer sentiment is also reflected in hard data where retail sales are trending upwards with the latest June print up 4.8% y/y. Car sales have surged more than 25% since bottoming during 2013 although the level is still around 50% down from the peak. Moreover, industrial production was up by 22.3% y/y in May implying the index is well above the level from the boom in 2005-06, confirming the acceleration in the recovery. Finally, with a large export share, Irish growth should benefit from improving growth in the US, the UK and the rest of the euro area. Role model among aid-receiving countries The economic progress in Ireland has resulted in a successful exit from the Troika programme and Ireland is often put forward as the role model among the aid-receiving countries. This follows as Ireland has undergone comprehensive labour market reforms resulting in a significant adjustment in labour costs: Irish unit labour costs dropped more than 20% from its peak while the euro average has increased in the same period. Moreover, the current account deficit, which was around 5% of GDP when the financial crisis kicked in, has been turned into a surplus. The improvement from 2007 to 2013 followed as real exports grew faster than GDP, reflecting that Ireland has benefited from improved export performance due to the steady improvement in competitiveness. The current account adjustment also reflects a slump in domestic demand, which implied that real imports receded somewhat. When domestic demand recovers, Ireland is likely to get a deficit again, but only a moderate one. Furthermore, the necessary adjustments should be supportive for more sustainable growth going forward. Unit labour costs have dropped more than 20% The current account deficit is turned into a surplus Source: Eurostat. Note: the Greek index is not seasonally adjusted Source: OECD Virtuous cycles getting stronger The Irish debt sustainability has started to improve. Public debt is expected to have peaked at 123.7% of GDP in 2013 and is projected to have declined to 121.4% in 2014. However, using the new GDP methodology, which all euro area countries will shift to in September 2014, imply gross debt was a bit lower at 123.3% of GDP in 2013. Based on the old statistical standards, the Irish budget deficit is set to drop from 7.3% of GDP in 2013 to 4.8% of GDP this year. Fiscal data YTD suggests that Ireland for the fourth consecutive year is set to beat its target and preliminary figures suggest a deficit of 4.2% of GDP. Using the new GDP methodology, the deficit could fall below 4% of GDP. The primary balance will be well within positive territory beating the -0.1% of GDP target. Ireland is well underway to reach next year s deficit target of 3% of GDP and exit the Excessive Deficit Procedure. 3 12 August 2014 www.danskeresearch.com
Government budget deficit to reach 3% in 2015 Fiscal headwinds continue to fade in Ireland 18 16 14 12 10 8 6 4 2 0 Change in cyclically-adjusted primary balance % of GDP 2011 2012 2013 2014E Ireland Euro area Source: European Commission, Danske Bank Markets Source: European Commission, spring forecast 2014 A stronger recovery with a positive spill-over to the public sector could result in a sharper drop in government debt than was envisioned in the 2014 Stability Programme. In our view, a positive scenario is not unlikely as virtuous cycles continue in Ireland. They were initiated by a more positive market sentiment, where a return of investor confidence resulted in lower sovereign yields. Later on, the improved sentiment spilled over to consumers and businesses where it has strengthened growth, reduced the unemployment rate and in turn improved the debt development. This has resulted in sovereign rating upgrades (see more below), which improves market sentiment and gives lower yields. Consequently, governments funding costs are reduced, implying less pressure for fiscal austerity measures and less headwind to growth. Using the assumption from the Irish 2014 Stability Programme, gross debt is set to drop to 98% of GDP by 2020, while adjusting for the new GDP methodological, debt is set to fall to 90% of GDP. A scenario with 1% higher nominal growth every year and 0.5% better primary balance (standard multiplier) would cause the public debt to drop to 81% of GDP by 2020. The Irish public debt can in addition be lowered if/when the Irish government starts on a reprivatisation of the banking sector, which was taken over by the government in 2010. It is difficult to come up with an estimate of how big these proceeds could be. The Irish government still holds a 99% stake in AIB and just below 15% of BoI. Both banks reported positive earnings in H1. Assuming that the Irish government sell assets amounting to EUR4bn each year from 2015-19 (totalling EUR20bn) would result in a further reduction of the debt down to 72% of GDP by 2020. Gross public debt could decrease faster than forecasted Lower rates supported by credit rating upgrades 135 125 % of GDP 115 105 95 85 75 65 Stability programme 2014 (adj. to ESA2010 and IBRC incl.) 1% stronger growth + 0.5pp better primary surpluss As above - including EUR20bn privatisation proceeds 2012 2014 2016 2018 2020 Source: Ireland Stability Programme and Danske Bank Markets Source: Macrobond Financial 4 12 August 2014 www.danskeresearch.com
Ireland has shifted to the ESA2010 which has resulted in a 6.6% lift to GDP for 2013. As a consequence of the altered methodology, IBRC has been reclassified from a bank to a defeasance a wind-down vehicle which is now being included in gross debt. IBRC is in the process of being liquidated and already by the end of this year the government liabilities from this change are likely to be less than 1% of GDP. In the above debt projection, the 2014 figure has therefore been adjusted lower by 6.5pp and 1pp in 2015 relative to the Stability Programme to account for the altered methodology and the wind-down of IBRC. Market drivers: rating cycle from vicious to virtuous As mentioned above, sovereign rating upgrades have supported virtuous cycles through improved market sentiment and lower yields. In Ireland, the rating has turned significantly since the exit from the Troika programme and the rating is currently Baa1/A-/BBB+ by Moody s/s&p/fitch with Stable/Positive/Stable outlook. On Friday, we expect an upgrade to a single-a rating, when Fitch has Ireland up for review. This should follow given the improvement in the budget outlook, accelerating Irish growth and progress in the banking sector (see our upcoming paper on Italy, where periphery banks are covered). These factors are the key determinants for the two rating agencies Fitch and Moody s, which still have Ireland below a single-a rating. Ireland is well on track in terms of the first two of the Fitch criteria for an upgrade and we believe that Fitch will upgrade Ireland, as the first two criteria have been stronger than expected. Irish banks H1 earnings and the buoyant housing market suggest it has also fulfilled the third criterion, although this part is more difficult to assess. In short, it should be sufficient that banks are steadily improving despite high loan impairments. Current ratings Ireland Moody's S&P Fitch Rating Baa1 A- BBB+ Outlook Stable Positive Stable Potential rating decision 12 September 2014 05 December 2014 15 August 2014 Requirement for upgrade Source: Moody s, S&P, Fitch (1) The government continues to comply with its fiscal consolidation targets, leading to significant improvement of government debt affordability as measured by government interest payments over revenues; and (2) the three major domestic banks regain profitability and reduce their combined non-performing loan ratio, further lowering the government's contingent liabilities from the banking system. Additional data confirming that Ireland's economic recovery is wellentrenched and that its fiscal deficits have narrowed to well below 3% of GDP. - Greater confidence that the GGGD/GDP ratio will be on a firm downward trend over the medium term. - Sustained, balanced economic recovery. - Reduction in financial sector vulnerabilities, notably an improvement in banks' asset quality and profitability. Another single-a rating (in addition to S&P) would, in our view, have a positive impact on the Irish market. This should follow as it would imply IRISH bonds would be included in more bond indices such as IBOXX single-a (currently Ireland is in the eurozone BBB- IBOXX index) and would have lower haircuts, etc. Furthermore, internal criteria are likely to have prevented central banks in particular from investing in Ireland and another rating upgrade should result in more investors being able to buy Irish government debt. The upgrade to investment grade had a big impact on the pricing of Irish government bonds and the effect is likely to be smaller this time but we expect to see greater interest. Conclusion: The strong economic performance in Ireland has continued and our forecast for 2014 is that it will be the strongest growth rate since 2007. Together with stronger growth, credit rating upgrades have supported virtuous cycles and public debt has started to decline. Another single-a rating would have a positive impact on the Irish market as it should result in more investors being able to buy Irish government debt. (See more about the development in public debt in the other periphery countries on the following pages). 5 12 August 2014 www.danskeresearch.com
Virtuous cycles in other periphery countries Public debt in Portugal is expected to have peaked at 129% of GDP in 2013 and looking ahead it will start to decline to below 125% in 2015. In 2013, the government budget deficit was lower than targeted as tax revenues were larger than planned. This suggests that virtuous circle have started in Portugal and if this continues and growth also gets stronger debt will decline faster than assumed in the Adjustment Programme while fewer austerity measures will probably be needed. Considering a scenario where nominal growth is 1% higher every year and the primary balance is 0.5% better, debt will decline to 99% of GDP in 2020 compared to 110% of GDP in the base scenario. In Portugal, the risk is that the constitutional court continues to reject austerity measures, but we expect the government to find alternatives, as it also did in 2013. The commitment is strong. Public debt in Portugal is expected to have peaked Tax revenues larger than planned in 2013 135 Debt % of GDP 130 125 120 115 110 105 100 95 90 Baseline from Adjustment Programme 11th review Growth 1pp higher + primary balance 0.5pp better 2011 2013 2015 2017 2019 2021 Source: Portugal s Stability Programme and Danske Bank Markets Source: Eurostat Spanish debt has not yet peaked, but among the periphery countries it constitutes the smallest GDP ratio as it has remained below 100% of GDP. The continued increase in debt is set to follow as the primary budget balance should remain in deficit in 2014-15. Nevertheless, in 2015 debt is expected to peak around 102% of GDP. The stabilisation should follow as economic activity continues to strengthen, which will result in lower unemployment and hence lower public expenditures. In case economic activity surprises on the upside, debt could start to decline faster than assumed in the Stability Programme. In a scenario where nominal growth is 1% higher every year and the primary balance is 0.5% better debt will remain below 100% of GDP in 2015. Moreover, it would decline to 84% in 2020 compared with 93% in the Stability Programme. Spain debt should not stabilise before 2015 But public expenditures should decline with unemployment 105 Debt % of GDP 100 95 90 85 80 75 70 Baseline from stability programme Growth 1pp higher + primary balance 0.5pp better 2011 2013 2015 2017 2019 2021 Source: Spain s Stability Programme, Danske Bank Markets Source: Bank of Spain, Eurostat 6 12 August 2014 www.danskeresearch.com
Italy has a very high public debt ratio, which was 133% of GDP in 2013. Although Italy has been struggling to return to growth, debt is projected to peak at 135% of GDP in 2014 as the primary budget balance has turned into a surplus. This has followed as Italy has managed to increase public revenues during the financial crisis in particular in 2012, when the technocrat unity government led by Mario Monti implemented austerity measures. Looking ahead higher economic activity is expected to put public debt on a declining trajectory. In case Mateo Renzi manages to boost domestic demand through reforms, it could result in a more optimistic scenario than what is currently forecast. In case nominal growth is 1% higher every year and the primary balance is 0.5% better, the debt ratio will decline to 102% of GDP in 2020 compared with 113% in the Stability Programme. Italy has a very high public debt ratio, but it has stabilised Primary budget surplus due to higher public revenues 145 Debt % of GDP 135 125 115 105 95 85 Baseline from stability programme Growth 1pp higher + primary balance 0.5pp better 2011 2013 2015 2017 2019 2021 Source: Italy s Stability Programme and Danske Bank Markets Source: Italian National Institute of Statistics (Istat) Greece s debt ratio increased to 174% of GDP in 2013, but, according to the IMF, it will stabilise and slowly start to decline from 2015. The IMF s forecast for public debt is based on primary surpluses of over 4% of GDP being achieved and sustained for several years while it also requires relatively high nominal GDP growth. According to the IMF, Greek authorities are on track to achieve the 2014 primary surplus target of 1.5% of GDP and there are even some upside risks due to higher-than-expected tax buoyancy as the economy recovers. On the other hand, preliminary estimates indicate a gap of around 1% of GDP in 2015 relative to the primary surplus target of 3% of GDP. In September, further debt relief will again be in focus in connection with the Troika s sixth review of the bailout programme. Greece public debt around 175% of GDP, but should decline However, it requires relatively high primary surplus Source: IMF Source: IMF 7 12 August 2014 www.danskeresearch.com
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