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July 14, 2016

Unholy Trinity

by Amareos.

Aside from the strong desire to discuss something other than Brexit, a topic we have covered in several recent blog posts, part of the reason for singling out Italy is because of all the 74 countries that we track country sentiments for it has the lowest reading, and by some considerable margin (see exhibit below). Even the UK, which is suffering the direct aftereffects of the Brexit vote (you just can’t get away from it can you!), has a higher sentiment reading.  A very telling result, indeed, as it suggests the Italy’s plight is even greater than the UK’s.

Exhibit 1. Country Sentiment Heat Map

Italy 1


Drilling down into the country sentiment data it is readily apparent that the decline in Italy has been extremely swift (see exhibit below). It is tempting – especially for Italian politicians for reasons we will explain in a moment – to attribute this deterioration to Brexit (there we go again!).

Exhibit 2. Italian Country Sentiment



But, on closer inspection it is clear that the decline in Italian sentiment began around the beginning of last month, well before the UK referendum (we have included the Italian stock index in the exhibit as the gyrations around the UK vote are clearly shown). So, while Brexit may well have added to the recent negative trend it is not the only, or arguably, even the most important driving factor.

As evidenced by the plethora of recent media headlines, investors are once more extremely concerned about the state of the Italian banking sector; concerns that were hardly mollified by Monday’s disclosure that the ECB had informed Italy’s oldest – and arguably most problematic – bank, Monte dei Paschi, that it must cut its nonperforming loans (NPL) by around 30% over the next three years.

True Monte dei Paschi has the highest NPL ratio of all listed Italian banks, but its problems are by no means idiosyncratic. Rather, it is just the worst example of a systemic problem. Contrary to the EU-wide decline in nonperforming loans, in Italy NPLs have continued to rise and are now estimated to be around 17% of the overall loan book – roughly three times the EU average.

That said, the unhealthy state of Italian banks’ balance sheets hardly constitutes “new news”. What is new though, and hence one potential contributing factor to the slump in Italian public sentiment, is that is increasingly obvious efforts by the Renzi government to tackle the problem are coming up short. For one, the Atlante bank fund set-up in April, which is backed by banks and institutional investors, totalled only EUR 5bn – a veritable drop in the ocean compared with the size of the problem (EUR 360bn of problematic loans on the balance sheets of Italian banks).

As an implicit recognition of this inadequacy, PM Renzi has been pushing his EU counterparts to relax regulations to allow an official recapitalization of the banking system on the basis that the Brexit vote constitutes “an exceptional circumstance”. His rationale for pursuing this line of argument is obvious – it is the one condition that would allow state aid to be provided without the strings attached to the recently adopted Bank Recovery and Resolution Directive (BRRD). Of these strings, the most politically problematic for Renzi is the bailing in of private creditors[1] given the experience of last year’s protests triggered by the rescue of four small Italian banks that resulted in 130,000 shareholders and bond investors losing their investments[2].

Unfortunately for Renzi, his attempt to circumvent the bail-in rule has been strongly rebuffed. German Chancellor Merkel[3] this week responded by saying (and we paraphrase) “rules is rules”. Similarly, European financial services commissioner Dombrovskis dismissed the notion that the Italian banking crisis had been triggered by Brexit; a perspective consistent with the pre-Brexit decline in Italian sentiment.

As alluded to above, even though Italy’s sclerotic banking sector is the most visible and immediate problem facing the country it is not the only one. There are two other (not altogether unrelated) problems that constitute the “unholy trinity” and, in our view, they are also responsible for the low levels of sentiment we observe in Italy.

Economic growth has been lacklustre to say the least. Since the Great Recession Italy’s average annual real GDP growth rate stands at -0.3% – an extremely poor performance that has greatly hindered any attempt to lower the public sector debt load, which on a gross basis has risen to 133% of nominal GDP[4].

When Renzi was first appointed prime minister in February 2014 he was the youngest person to hold that position in over a century. Together with his pro-reform rhetoric, this fuelled a wave of economic optimism – an effect clearly discerned in the sentiment data (see exhibit below which plots sentiment towards Italian economic growth). What is also clear though is that this economic optimism has faded markedly over the past year[5]. Moreover, there is a marked disinflationary whiff to recent sentiment-based measures of expected inflation – a very troublesome development for an economy so heavily indebted.

Exhibit 3. Italian Economic Growth And Future Inflation Sentiment

Italy 3


The third, and final, element of the unholy trinity is domestic politics; a longstanding and well-recognized problem in Italy. In order to streamline the political process Renzi introduced a constitution bill that effectively replaces the Upper House – the Senate – with officials and state-nominated members. It also seeks to limit the Senate’s legislative veto. Having failed to secure the two-thirds majority in both houses of parliament to enact the bill directly it had to be put to the public in the form of a referendum[6].

For those backing the referendum, the hope is a more efficient legislative process will reinvigorate the economic/structural reform drive, boost productivity and thereby lift the country’s potential economic growth rate.

Admirable as this end goal may be opinion polls suggest that the referendum may not succeed. Not only is there great concern that the electoral reform is undemocratic, by removing a key check in the legislative process, but there is rising swell of public discontent with the Italian political class in general. This trend, which we can pick-up in our sentiment-based measure of political risk (see exhibit below), has boosted support for the anti-establishment Five Star Movement (M5S) helping them win the recent Rome Mayor election[7].

Exhibit 4. Italian Political Risk Indicator

Italy 4


To underscore his commitment to constitutional reform Renzi has publicly stated that if he does not win October’s referendum he will emulate Cameron and resign as prime minister – an eventuality that would not only be dangerous to Italy, given the current precarious state of its banking system, but would also spell trouble for the entire single currency project.

As mentioned above, Italian government debt is large, so large in fact that it will be almost impossible for the EU infrastructure to cope with a Greek-style debt crisis. For now evidence of contagion from the banks to the sovereign is limited. Italian 10-year nominal government bond yields are trading around 1.2%[8], implying a spread over the equivalent Bund of roughly 140bp. This compares with the 400bp+ spread observed in 2011 during the height of the Euro crisis. ECB purchases of Italian government debt as part of its EUR 80bn monthly QE programme are – and can – help contain this spread widening to some extent, but the wiggle room is very limited. Of course, ECB government bond purchases can always diverge from the capital key in favour of Italy, but not in the magnitude that will be required in the event of an accident in the BTP market without sparking a serious political – possibly legal – storm.

All told, there is considerable justification for such deep pessimism in Italy as it looks like it is going to be a long, hot, summer in the Med!

Sentiment Analytics are based on MarketPsych indices. 

[1] A condition imposed to lower the cost of bank bailouts to the public purse.

[2] Italian retail investors have a greater presence in the market for bank bonds compared with most other countries because of the tax code.

[3] See:

[4] Obviously, weak economic growth is also a factor behind the high NPL ratios in the banking sector.

[5] This is despite the uptick in last month’s composite PMI surveys.

[6] Can one read that word yet without triggering an emotional shudder?

[7] It was around the same time that M5S did well in the regional elections that Italian country sentiment began to drop. This is simply an observation, we are not implying there is a causal relationship as it could simply be coincidence or reflect a common underlying cause. (Also it is worth noting that, like the UK, immigration is another hot political topic.)

[8] At almost every point in time over the last century a 10-year nominal Italian government bond trading with a yield of 1.2% would have been a cause for massive celebration. However, in a world where investors are effectively paying to lend governments money to the tune of more than USD 10 tr globally, such yields levels are not a sign of strength but rather weakness.


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