Euro Macro: Italy’s recession points to much larger budget deficit – The economic outlook for Italy has deteriorated rapidly. According to the official definition Italy’s economy entered a recession in the final quarter of last year, with GDP contracting by 0.1% qoq in 2018Q3 and by 0.2% in Q4. Since then, it seems to have moved even deeper into negative territory. Indeed, Italy’s composite PMI dropped to 48.8 in January, which is consistent with GDP contracting at a rate of around 0.3% qoq in 2019Q1. Due to the longer than expected recession, we have reduced our GDP growth forecast for 2019 as a whole to -0.3%, down from our previous forecast of +0.3%. In this scenario we have still assumed that Italy’s GDP growth will move back to a bit above zero after the first quarter as we expect some improvement in the global economy and word trade. Also, the planned fiscal stimulus by Italy’s government should support growth somewhat. Having said that, the risks to this scenario are clearly tilted to the downside, as financial conditions in Italy could tighten and confidence could be hit in case of a new deterioration in financial market sentiment, which could be triggered by a renewed conflict with the European Commission about government finances.
The deteriorating outlook for Italy’s economic growth strengthens the view that the budget deficit will significantly over-shoot the government’s targets. Initially, the government was targeting a deficit of 2.4% GDP in 2019. This was underpinned by an economic growth forecast of 1.5% for this year. Following pressure from the European Commission and other governments, the Italian government reduced its deficit forecast to 2% for this year, before declining to 1.8% in 2020. Meanwhile, it also reduced its economic growth forecast to 1% for 2019. It was not clear at the time what measures it would take to ensure that the deficit came in lower, especially since lower economic growth would mean lower tax revenues. Our lower GDP growth forecast implies – on its own – that the government budget deficit will be 0.6% GDP higher than it is projecting. Indeed, compared to the original GDP growth forecast, the deficit – if our projection is correct – would actually be 0.9% GDP higher. In addition to likely further disappointments in terms of the macro outlook, we think that the measures that the government has implemented will be more expensive than the budget assumes. It is committed to making spending cuts to offset any cost over-shoots (in addition to planned rises in VAT) but it is unclear whether it will achieve those. Overall therefore, we expect the budget deficit to be considerably higher than projected, at close to 3% GDP in 2019 and 2020. Given this, we remain of the view that the government debt ratio will trend up in the coming years, in contrast to the government’s expectation that it will decline.
Against this background, we are cautious on Italy’s government bonds at current levels. Our base case is that the 10Y spread between Italy’s government bond yield and that of their German counterparts will rise to around 275bp (compared to 260bp at time of writing). We think the bond market priced in too much good news following the government’s climb-down when it reduced the deficit target (although there has been some correction in recent days). With fiscal outcomes likely to disappoint, markets may price in more credit risk, especially as this could re-ignite tensions with the European Commission. We see upside risks to spreads relative to our base scenario.