Our macro framework continues to suggest the global business cycle is slowing, led by deceleration in Europe and emerging markets. In contrast, U.S. growth remains resilient despite steady tightening in monetary policy. Furthermore, global risk appetite remains weak, leading us to maintain a moderate underweight to global equities and an overweight to duration, despite the recent jump in bond yields.
Within developed markets, we further reduced our exposure to European equities in favor of U.S. equities, given the realization of one of the main risks we flagged back in September: Italy.
Italy and the Long Distance Between Rome and Brussels
The newly elected Italian government is testing the patience of the European Commission, with a new budget deficit proposal around 2.4% of GDP for 2019, 2.1% in 2020, and 1.8% in 2021, substantially higher than the projections of the previous government. As it stands, the proposal breaches the European Union rules of long-term debt sustainability incorporated in the Stability and Growth Pact. Financial markets have taken notice, with the Italian 10-year yield spread over Germany rising to 300 basis points (Exhibit 1), followed by underperformance in Italian and European equities, and modest depreciation in the euro.
We believe the market reaction is appropriate at this stage, as there are several aspects of this budget that concern investors:
- Budget composition: The proposal is geared mostly toward subsidies, aimed at supporting short-term demand, rather than boosting long-term growth via capex, infrastructure, or R&D.
- Growth assumptions are too optimistic: The government assumes large fiscal multipliers and a nominal GDP growth north of 3%, a high bar for Italian standards even under the favorable cyclical conditions of the past two years.
- Bad timing: Italy is testing debt markets at a time when the European Central Bank’s quantitative easing program is coming to an end, while European growth is showing clear signs of deceleration (Exhibit 2).
- Confrontational political rhetoric: The governing majority in Italy, formed by the Five Star Movement and the Northern League, has campaigned on promises to break free from European austerity rules, and their rhetoric thus far continues to challenge the European status quo. We believe the Italian government will choose to ignore the “warnings” of the European Commission and move forward with their budget.
Italy is not Greece, as we often hear. Nonetheless, Italy is not in a position to run large budget deficits because, at the end of the day, it doesn’t print its own currency. With a stock of public debt hovering around 130% of GDP (higher than during the 2011-2012 European debt crisis), debt servicing costs at 4% of GDP, and nominal GDP growth at 3%, Italy’s math does not add up. Furthermore, rising yields and falling equity markets quickly erode business and consumer confidence, which dampens the expansionary effects of fiscal policy. While there has been no contagion to other peripheral bond markets (namely Spain and Portugal), the banking system remains the main conduit for contagion risk. As we learned during the debt crisis, widening spreads have the potential to weaken banks’ balance sheets, curtailing credit creation and economic growth and, in turn, weakening governments’ fiscal positions.
At this stage, it is unclear what the resolution will be. The Italian government is determined to move forward with the current budget, and financial markets are still in the process of pricing in the implications. For now, we remain defensive.
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