Italy: fundamentals are the compass amid political twists

Italy: fundamentals are the compass amid political twists Eric Brard Head of Fixed Income Annalisa USARDI, CFA Senior Economist With the contribution of: Giuseppina Marinotti Investment Insights Unit The contract between the two parties will be the wish list of the new government. Uncertainty remains on how it will be executed and on implications on public finance targets. 1 A new Government: After three months of deadlock, 5Star Movement and the League agreed on a redesigned Government formation. Prof. Conte was again designated as Prime Minister. The contract between the two parties will be the wish list of the new government but uncertainty remains on how it will be executed and on implications for public finance targets. Economy: The macro-environment that Italy is facing is much more positive than the one during the Euro Sovereign Debt Crisis in 2011: In Q1 2018, Italy has enjoyed expansion for 15-quarters in a row. Overall, we still think that the economic fundamentals remain positive, yet we acknowledge that the current situation may significantly disturb business and consumer confidence. Overall, this is the key thing to watch to identify early signals in activity. Strengths and weaknesses: From the financial point of view, Italy s main problem is the high level of government debt, although the high average maturity (6.8 years) somewhat protects it from a sudden transmission of higher interest rates into debt dynamics. Private sector debt is one of the lowest of the Eurozone. Household and corporate financial vulnerability would remain limited even in the case of a rise in interest rates. The Italian banking system soundness has increased: The share of NPLs (Non-Performing Loans) in banks' balance sheets is declining progressively, especially for banks that have made largescale disposals. Fixed Income: Going forward, the level of volatility will continue to be influenced by the news flow and will probably stay high until some crucial issues, especially in terms of fiscal budget, become clearer. We expect the ECB to stick to its mandate and agenda. Our central scenario is a progressive reduction of purchases for an end in December 2018. For the time being, we prefer to keep a cautious approach, and be very flexible (in duration and risk exposure) as conditions can rapidly evolve. It is too soon to step in, but we will clearly look for the right time over the course of the summer to enter the market. What is the recent evolution of the Italian political crisis? Usardi. After three months of deadlock, on 31st May, the two leading parties the 5Star Movement and the League - agreed on a redesigned Government formation. Prof. Conte was again designated as Prime Minister. He presented the list of Ministers, removing the obstacle that stopped previous government formation attempts. The most controversial figure (Paolo Savona, economist, whose nomination as Minister of Economy and Finance caused previous attempts to form a government to fail) was moved to another ministry, while some key ministries remained non-political, albeit held by experienced figures in previous governments (e.g. Minister of Economics and Finance, Giovanni Tria, over the years has served as a senior advisor in various ministries such as Economics and Finance, Foreign Affairs, Public Administration, Labour). Both leaders of the coalitions (L. Di Maio and M. Salvini) have a role as both Ministers and vice Prime Minister. Since that date, the Government has his full powers and should get the confidence vote in the coming hours, with the support granted by the votes of the M5S, the League and some senators of the Gruppo Misto in the Senate (where the majority by the M5S and the League would be slim). The contract between the two parties will be the wish list of the new government, but uncertainty remains on how it will be executed and on implications on public finance targets. What is your assessment of the Italian economy? Usardi. The macro-environment that Italy is facing is much more positive than the one during the Euro sovereign debt crisis in 2011. On the fundamental macro front, at the beginning of the year, we expected the positive momentum of 2017 to be carried over into 2018 (albeit with some moderate growth) maintaining output growth well above potential. Growth and recovery INVESTMENT TALKS 5 June 2018

In Q1 2018, Italy has enjoyed expansion for 15-quarters in a row, and experienced a somewhat extraordinary growth at 1.5% YoY in 2017, well above the estimated potential. were well under way so far: as of Q1 2018, Italy has enjoyed expansion for 15-quarters in a row, and experienced quite extraordinary growth at 1.5% YoY in 2017 (vs less than 1% in 2016), well above the estimated potential. This performance was supported by all the growth engines and especially by the recovery in capital goods investments, which is accelerated compared to the past two years and broad based across sectors and capital goods. Support came also from personal consumer goods, with a sustained pace of growth thanks to upbeat confidence; and finally net exports benefitted from the expansion in global output and trade, supported by increased competitiveness. The positive environment created by the ECB monetary policy helped to sustain the recovery. Value added increased in all sectors, in particular in the industrial manufacturing sector. The slack in labour market was gradually absorbed, although the unemployment rate still remains around 11%. Overall, we still think that the fundamentals of the economy remain positive, yet we acknowledge that the current situation may significantly disturb business and consumer confidence, therefore affecting the real economy through deferral in investment and consumption decisions. Overall, this is the key thing to watch to identify early signals on activity. What are the country s main vulnerabilities? From the financial point of view, Italy s main problem is the high level of government debt, while the private sector debt is not of concern. Government finance is slowly getting better (public debt to GDP in 2017 was 131.8% - in 2016 it was 132%, a small decrease but with commitment to decrease further); deficit to GDP in 2017 was 2.3% (vs 2.5% in 2016) with an objective for 2018 of 1.6% (-0.7% vs 2017). In the plans, a progressive decrease of deficit was projected to reach a balanced budget in 2020 and a small surplus on 2021. Italy runs a primary surplus at 1.5% of GDP, stable vs 2016, with fiscal pressure on average decreasing from 42.7% to 42.5% in 2017. The high level of government debt represents a risk, although the high average maturity (6.8 years) somewhat protects it from a sudden transmission of higher interest rates into debt dynamics. The ratio of non-domestic holders was 33.2% in April 2018. The high level of government debt represents a risk, although the high average maturity (6.8 years) somewhat protects it from a sudden transmission of higher interest rates into debt dynamics. The debt issue and concerns on fiscal deterioration 210% Debt/GDP ratio (%) 180% 150% 120% 90% 60% 30% 0% SURPLUS DEFICIT 4.0 Deficit/GDP ratio (%) 3.0 2.0 1.0 0.0-1.0-2.0 Source: Amundi, as of June 4 2018. Household debt is among the lowest within the Eurozone, at 60% of disposable income (vs France and Germany approx. 80%, Spain 100%) and delinquency rates are low; vulnerable debt is around 11.4% vs 24.2% in 2008 and stress test simulations by the Bank of Italy predict that +100 basis points 1 (bps) on interest rates moves vulnerable debt to 12.4%, +200 bps moves vulnerable debt to 13.4%. Their financial vulnerability would remain limited even with a sharp rise in interest rates. Companies leverage is now down to 40% (France and Germany 32% and 37% respectively) with a marked decline in debt held by vulnerable companies (45% in 2012, down to 32% in 2016, expected at 28% in 2018). Stress test simulations by the Bank of Italy would imply that this ratio would still be in decline even with +100 bps increase, while +200 bps would move debt held by vulnerable companies to 32%). The continued economic recovery 1 Basis point (bps) refers to a common unit of measure for interest rates. One basis point is equal to 1/100th of 1%, or 0.01%. 2

supports corporate profitability, reducing businesses vulnerability. Yet, fragilities persist among small firms and in the construction sector. Private sector debt (% of GDP) one of lowest in the EU 250 200 150 100 50 0 Source: Amundi, as of June 4 2018. Italy Ireland Germany France Spain Portugal Euro area Households Non-financial firms Overall, Italy s banking system has satisfactory levels of liquid assets to weather even very large increases in risk-free interest rates. Since the last crisis the supervision of the banking sector has been strengthened and unified under the ECB supervisory role and falls under the project of the European Banking Union. Banking sector has been under pressure in the last few weeks. What are banking sector conditions? Referring to the Bank of Italy Financial Stability Report of April 2018, the Italian banking system s soundness has increased. The quality of bank credit has been improving steadily. Flows of non-performing loans (NPL) have now returned to levels comparable to pre-crisis levels. The share of NPLs in banks' balance sheets is declining progressively, especially for banks that have made large-scale disposals. Several capital increases narrowed the gap in capital strength compared to the average in other European countries. Furthermore, bank profitability is improving, yet, it is still assessed to be quite poor for many small and mediumsized banking institutions. Overall, Italy s banking system has satisfactory levels of liquid assets to weather even very large increases in risk-free interest rates. The Bank of Italy has performed stress test of the sectors to assess resilience to interest rates shocks. Three scenarios in which risk-free interest rates rise by 100, 200 and 300 basis points (bps) over the entire yield curve have been examined, assuming constant risk premiums (vs base scenario as curve levels out at the end of January 2018). The results show that even in the worst case scenario, where the system s average loan coverage ratio declines from 172% to 143%, it still remains above the regulatory minimum of 100%. Assuming a 100 bps rise in risk-free interest rates, 2.6% of banks would fall below the threshold, representing 2.7% of total assets. Assuming 200 bps rise, 4.3% of banks would fall below the threshold, representing 5.0% of total assets. Assuming 300 bps rise, 4.6% of banks would fall below the threshold, representing 5.4% of total assets. What has changed regarding the European financial sector since the last European crisis? The Euro area debt crisis made it clear that deeper integration of the banking system was needed for the Euro area countries, given their interdependence. Since 2011, the ECB and the Eurozone have shown commitment to actively prevent and manage financial stability with a number of tools: The European Stability Mechanism (ESM) has been established as a permanent crisis management mechanism, the ECB has extensively used its balance sheet to purchase assets and some progresses have been made towards the Banking Union. Since the last crisis, the supervision of the banking sector has been strengthened and unified under the ECB supervisory role and falls under the project of the European Banking Union. The Banking Union roadmap is based on three pillars. The first two pillars are now fully operational, the single supervisory mechanism (SSM) and a single resolution mechanism (SRM) for banks, which strengthen and unify the supervision of major banks in all member countries. The third pillar was proposed by the European Commission, as a further step toward the Banking Union, (in Nov 2015): The European deposit insurance scheme (EDIS) to provide stronger and more uniform insurance cover for all retail depositors in the Banking Union. EDIS would provide a 3

stronger, more uniform degree of insurance cover in the Euro area, reducing the vulnerability of national deposit guarantee schemes to large local shocks and ensuring that the level of depositor confidence in a bank would not depend on the bank s location. It s important to have a strategy to face this uncertain phase, and the most appropriate one in our view is to relying on fundamentals. In fixed income, what do you expect in terms of market volatility? Brard. While the peak of the Italian institutional crisis seems over, the new government will have to deal with a number of challenges and the market will closely monitor actions and decisions that will be taken to implement the contract signed by the parties leaders. Going forward, the level of volatility will continue to be influenced by the news flow and will probably stay high until some crucial issues, especially in terms of fiscal budget, will be clearer. It s important to have a strategy to face this uncertain phase, and the most appropriate one in our view is to rely on fundamentals. This was a political crisis, but Italy has a number of favourable parameters. These positive factors will continue to help mitigate the turbulence created by political twists. What is your view on ECB policy in this context? Brard. The ECB is not to be considered the deus ex machina in this matter, and we should expect the ECB to do the Central Bank job maintaining price and financial stability and not reacting to political crises. We expect the ECB to stick to its mandate and agenda: The ECB should formally announce soon how it intends to end its purchasing program. Our central scenario is a progressive reduction of purchases for an end in December 2018. Despite the Q1 softening, the current economic expansion is still sustained in Italy and in other Euro Zone countries. It will be important to look at business and consumer confidence indicators in the coming weeks to see to what extent the soft patch is taking shape and on Italy, if the political crisis has weakened confidence. While we remain in a wait and see attitude for the moment, we expect that the positive fundamentals in the Eurozone could soon pave the way for interesting opportunities going forward. How should investors deal with the current uncertain phase? Brard. For the time being, we prefer to maintain a cautious approach, and be very flexible (in duration and risk exposure) as conditions can rapidly evolve. The overall assessment of current situation is somehow mitigated looking at the two layers, Italy and the Eurozone. The landscape in the Eurozone is very different from 2011. Europe is in a different phase of the economic cycle, growth is now solid and broad-based. Interest rate figures are very different as well: 10y Italian sovereign yields were just above 3% in the middle of the institutional crisis, in November 2011 they went above 7%. The Bank of Italy was recently reminding us that the cost of debt is around 3% and most of the curve is below 2.5%. And overall, the spillover to the other European markets has been contained. While we remain in a wait and see attitude for the moment, we expect that the positive fundamentals in the Eurozone could soon pave the way for interesting opportunities going forward. As we said, we will continue to monitor the political situation, the economic figures (in particular developments in debt), investors attitude and liquidity conditions. Liquidity conditions are very important in volatile phases: liquidity pressure during the sell-off of Italian assets contributed to generate market dislocations. It is important to have a set of policies regarding liquidity to try to protect investors against liquidity black holes. In conclusion, it is too soon to step in, but we will clearly look for the right time over the course of the summer to enter the market. 4

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