The planned fiscal expansion is far smaller than initially feared, suggesting an over-reaction in markets, argues Azad Zangana, Senior European Economist and Strategist at Schroders.
The Italian 2019 budget target was unveiled on 27 September 2018, with the government defying the proposal of Giovanni Tria, Italy’s Minister of Economy and Finance. Tria had recommended a deficit of 1.6% of GDP, which would have largely satisfied the European Commission, however, the target has been set at 2.4% of GDP, with additional funds being prepared for pre-election promises.
Italy is now on a collision course with the European Commission, which will assess all member states’ budget plans from 15 October. It is very likely that the Commission will instruct Italy to lower its target, although it has little power to force Italy to comply. The Italian government will point to France, which plans to overshoot its previous 2019 target. The European Commission will probably manage to persuade the Italian government to lower its target slightly, but France’s behaviour is not helping matters.
Italian equities and bonds slump in reaction to fiscal overshoot
The initial reaction in markets to the news has been negative. The Italian FTSE MIB equity index fell by almost 4% the following morning, with Italian banks suffering the most, as they are large holders of Italian government debt.
The yield spread between the 10-year Italian government bond (BTP) and German 10-year bond rose by around 30 basis points. However, the spread remains well below the peak seen over the summer, when uncertainty over the 2019 budget and rumours over the possible sacking of the more moderate finance minister helped push the spread to highs not seen since 2012.
This period of fear followed the formation of Italy’s populist coalition government. The coalition members, the League and Five Star Movement parties, joined forces by agreeing a fiscal programme that, if fully implemented, would likely expand Italy’s budget deficit by around 5% of GDP (to around 6.6%) over a two to three-year period. Policies that have been promised include scrapping a planned hike in VAT, the introduction of a flat income tax, a tax amnesty, a minimum citizens’ income and an unwind of pension reforms.
Looking ahead, the small expansion of policy (0.8% of GDP) announced in the 2019 budget is by no means a disaster, as with growth and inflation taken into account, Italy should see debt fall as a share of GDP next year. The European Commission will protest over the fiscal slippage in the coming months, but markets are likely to be relieved that the government has only partially followed through with its manifesto promises. Full implementation of those promises could have led to a far higher rise in bond yields, and a quick deterioration in public finances.
Market reaction overdone
In the near term, we expect most investors to warm back up to Italy. Despite all the bluster, the government only plans to loosen fiscal policy slightly, and within the tolerance of markets. Moreover, the yield on offer in Italy will be difficult to ignore, especially when European investors have few places remaining to generate a decent income. We expect the spread between Italian and German bonds to narrow in the coming months, and for the news flow to become more neutral.
A sense of calm is likely to return; however, the elephant is still in the room. Italy’s government has not suddenly become a coalition of liberal fiscal conservatives. The political pantomime will probably repeat itself this time next year when setting the 2020 budget. Meanwhile, Italy will remain vulnerable to any hit to growth, be it cyclical or a shock.
In the long term, we are still concerned over the sustainability of Italy’s public finances. Poor demographics, a lack of investment and weak productivity growth are likely to cause the economy to stagnate for decades to come. Debt will probably become an issue, and with Italy stuck in a monetary union, Italy lacks the ability to devalue its currency or to manipulate its bonds yields.
Long term concerns will remain, but in the near term, the market appears to have over-reacted.
This article has first been published on schroders.com.