Now that the initial shock from the formation of an anti-establishment, populist government in the Eurozone’s 3rd largest economy, has passed banks are starting to focus on the concrete policy proposals that will soon be attempted and implemented by the 5-Star/League coalition. And, as is widely known especially by Brussels bureaucrats, the proposed fiscal plan will put Italy’s public finances under pressure, as it’s based on large spending increases and uncertain revenues, in some ways similar to Trump’s own fiscal stimulus. This, according to Morgan Stanley, likely means (much) higher borrowing costs and downward pressure on the sovereign rating.
Among the various possible outcomes, a moderate budget deterioration may just weaken the state coffers, while a large one would probably put debt/GDP on an upward trajectory and lead to a debt crisis. Meanwhile, proposals such as mini-BOTs, with the risk that they’re taken by the markets as quasi-currencies, raise the risks further, even if as JPMorgan analyzed over the weekend, a “Quitaly” scenario, in which Rome exits the Eurozone, just may be the best option for the country.
In order to analyze the various possibilities, Morgan Stanley’s Daniele Antonucci modeled out three discrete scenarios. First the neutral/good cases:
The base case: Walking a fine line (60% probability). The Five Star Movement and the League implement some of their flagship policies, but not all, and partially fund them. They do some structural reforms, but advocate changes to some aspects of the EU and the euro rules.
- The debt path trends downwards, but only slightly. Confidence remains shaky at first, but the economy responds positively to the fiscal stimulus
- No meaningful European or euro policy change gets announced
- The ECB uses its existing tools to mitigate contagion, but no specific BTP market support
Bull case: Room for reform (10% probability). Italy maintains a healthy primary surplus, engineers some structural reforms and supports European integration:
- The debt path trends downwards. Confidence improves
- The European policy debates get easier
- The ECB doesn’t need to act in a meaningful way
Finally, the downside, i.e. “debt crisis” case, which has a roughly one third chance of taking place:
Bear case: Bumpy ride (30% probability): The Five Star Movement and the League implement most of their policies, with only limited funding. They do some structural reforms, but remain highly critical of some aspects of the EU and the euro architecture
- The debt path trends upwards. Confidence keeps falling, but a significant fiscal stimulus is an offset
- Market concerns about the parties’ policies intensify
- Following a significant financial and economic impact, Italy applies for ESM support and qualifies for ECB OMT bond buying
With these scenarios in mind, this is how Morgan Stanley’s various modeled outcomes look over time, first a look at the sensitivity to Italy’s interest rates in the context of fiscal loosening (rates will go up as Italy gorges on debt).
The chart below shows that, at unchanged fiscal policies, a 100bp increase in interest rates would make debt/GDP trend down, but very slowly, thus leaving its path vulnerable. The far more likely outcome of a 200bp increase in rates would make it trend higher
Next, from a purely economic standpoint, there is the question of the amount of primary balance needed to stabilize the debt, and what fiscal mulitiplier would be necessary to grow out of the country’s debt.
Here, as Morgan Stanley concedes, even abstracting from a hypothetically more expansionary fiscal plan, Italy’s debt path is only stabilised under very favorable circumstances – low funding costs, at least some economic growth and inflation and, crucially, making ends meet. All of these will be next to impossible as the ECB’s gradually fades its various bond purchase programs. As a result, with interest rates rising, the economy decelerating again and inflation quite low, it all comes down to maintaining, if not increasing, a substantial fiscal cushion. Over the longer term, a 200bp increase in interest rates would require a primary surplus of about 3.5% of GDP to stabilise the debt trajectory, approximately twice as large as currently. A more moderate rise in debt-service costs, e.g., 100bp, would require a primary surplus of almost 2.5% of GDP – not right away, obviously, but over time.
Alternatively, instead of keeping impossibly large primary surpluses, the alternative would be to engineer such a big fiscal boost, e.g., via the implementation of the full plan, to spur a strong recovery. This also looks unrealistic to Morgan Stanley, as to stabilize debt/GDP, the pace of economic expansion should accelerate to more than 7% initially, three to four times faster than currently. Taking rising funding costs and falling sentiment into account, not to mention Italy’s deteriorating demographics, this looks impossible unless one was to assume a fairly large fiscal multiplier (just don’t invite the IMF to structure the plan).
Finally, the most troubling chart, is the one showing the projected debt/GDP level under the three core scenarios. Needless to say, the full implementation of the Five Star Movement-League plan would make public debt trend much higher, and more abruptly, eventually resulting in a debt crisis. The silver lining: the IMF’s forecast that the US debt/GDP would surpass Italy’s will never see the light.
Well, of course: if rates rise and if Italy issues another mountain of debt to kickstart growth, of course Italian debt will explode, hardly anything new there. A far better question is at what levels of interest alone does Italy’s debt become unsustainable. To answer it, MS has created a debt sustainability matrix, shown below. Here’s how to read it: the combinations of nominal growth and primary balance in yellow are those where debt/GDP rises, for a given interest burden. The area in blue shows the combinations where the debt falls. The good news is that Italy is currently in the blue area (circled cell). The bank’s assumptions, though, show that, given a projected deterioration in the primary balance, the decline in the debt burden is likely to be much slower.
This exercise shows that a primary budget deficit, as the full Five Star Movement-League plan implies, would require very fast growth of between 4%Y and 5%Y even at today’s level of interest rates. Should they rise, the blue area would shrink, making the debt burden heavier.
Getting even closer to the market, MS then lays out a rather bizarre cross plot plot of various key sentiment indicators (Istat business and consumer confidence, composite PMI) and Italy’s 10y government spread at fixed points in time. The idea is to capture how much confidence has tended to drop for a given spread widening by looking at fixed time intervals, in other words what is the intangible, psychological impact from a blow out in Italian yields.
The picture that emerges is that in some past episodes sentiment did fall quite a lot, while in others not so much. The spread-widening period when sentiment fell the most was 2007-09, although a lot more than just spread widening was going on back then. The longest period of sentiment decline was the euro crisis in 2010-11. The shortest period of widening was 2015-17. Despite this significance variance, it does seem that for a widening of 100bp sentiment tends to fall by 5-10%. Anything notably above that could lead to an exponential drop off as the investing (and general) public braces for the worst.
There is still hope, if only on paper: a large fiscal boost can surely propel the economy onto a higher growth trajectory. However, when it’s a highly leveraged sovereign such as Italy (or the US, but Trump has the benfit of holding the reserve currency) that engineers the stimulus, the rise in borrowing costs, when that feeds into higher rates for mortgage and corporate loans, is an offsetting factor. When this process happens in a disorderly fashion, perhaps also because of concerns about the sustainability of the fiscal deterioration in the context of ensuring continued euro area membership, the equity market also tends to fall. The impact of a tightening in financial conditions could be significant. For example, a 100bp upward shift across the sovereign curve could reduce GDP by 0.3% after one year and 0.5% after two years.
A weaker currency then, Morgan Stanley concludes similarly to JPMorgan, becomes the only offsetting factor. Of course, the problem is that for Italy that is not an option… for now.
There does remain the ECB wildcard.
Debt sustainability and interest rate sensitivity risks were moderated by President Draghi’s ‘whatever it takes’ speech in July 2012 and especially after the start of the ECB’s QE programme in March 2015. However, with the risk regarding the euro project manifesting itself as the Italian situation unfolds, debt sustainability risks are now being recalibrated by the market. In Morgan Stanley’s “base case”, fiscal expansion will still allow for the debt burden to decline, albeit at a much slower pace. This is partly due to falling interest rates in the past five years and the lengthening of the average debt profile of Italian government debt since the peak of the crisis (Exhibit 29), which allows for a gradual pass-through of rising market interest rates to its debt-service cost.
However, the interest trajectory looks far worse under somewhat more realistic assumptions. Exhibit 30 shows the debt-service cost sensitivity to market rates:
- With a large fiscal expansion scenario, i.e., “bear case”, factoring in the current BTP forward curve levels, which have already repriced more than 100bp higher for the 10y BTP in the last week, it suggests that the debt-service cost will take roughly nine years to rise by a full 100bp;
- If there is another 200bp permanent and parallel shock to the BTP forward curve, the debt-service cost would rise much more meaningfully, and reach the level we saw during the sovereign debt crisis by 2021.
The bigger problem with the ECB wildcard is that it is at the root of the problem, because while on one hand Italy wants its fate to be independent of Mario Draghi’s goodwill, and potentially his currency, it also wants cheap interest rates. The two are incompatible, especially if Italy were to remain in the Eurozone and the ECB were to finish its QE as it expects to do some time in early 2019.
Which brings us to what MS – and everyone else – believes is the biggest threat from a market standpoint: The Lack of a marginal buyer.
Here, as MS notes, the ‘buy on dip’ mentality has been a successful strategy for European sovereign bonds since the sovereign debt crisis, given the institutional backstop we have had since then. Since the peak of the crisis, the market has undergone a prolonged period of risk transfer of BTP holdings from foreign investors to the euro system and domestic investors (shown below) something we first discussed last December when we first observed that the ECB has been the only buyer of Italian bonds in the past few years.
The current investor breakdown of Italian government debt suggests that the majority of the bonds are now held by the combination of the euro system and the Italian domestic investors holds nearly 70% of the marketable debt stock (Exhibit 36).
While, superficially, this holding structure could imply less forced selling in times of stress such as now as the buyers are admittedly price- and cost-indescriminate, what is different between now and the sovereign crisis is that since then peripheral governments have had falling budget deficits due to austerity and falling interest rates, which led to falling net issuance in the past five years. This coincided with strong buying power from domestic investors and the euro system to absorb the selling flows.
Now, with the limited power of the ECB, coupled with a significant rise in net issuance, who will be the marginal buyer for the additional issuance is a key question.
And here is the most troubling observation from Morgan Stanley, if only to BTP bulls:
“Looking at the investor base, we believe that there may not be any obvious candidate to support the BTP market if a bear case fiscal expansion was to play out.”
In short: whereas there always has been a deus ex machina to prop up Italian bonds over the past decade, very soon there won’t be. At that moment that “carry trade” will go into reverse, and what was a scramble to bid up BTPs will become a panicked frenzy for the exits.
Putting all of the above together, Morgan Stanley predicts a bumpy road ahead for BTP-Bund spreads: as we witnessed first hand in the past two weeks (when as we discussed earlier, the ECB dramatically pulled back its purchases of BTPs to make a very clear anti-populist point), the political uncertainty has certainly reintroduced a significant credit premium into BTP-Bund spreads, removing the QE premium from the BTP markets. With the potential increase in the fiscal plan and rhetoric from the FSM-League coalition that could undermine the euro project, it is difficult to envisage any meaningful buying support for Italian government debt in the near term.
The bank’s conclusion: if you are long Italian bonds, now may be a good time to get out:
Even though we expect a moderation of the fiscal plan after some positive political shift in our economists’ base case, we see the risk of a further deterioration in market sentiment before a shift in the policy. This means the trajectory for BTP markets and wider sovereign markets can follow our bear case before it settles back into our base case. This would imply further spread widening and curve flattening before a retracement can happen in the medium term. We lay out our spread and curve scenarios according to our economists’ bull/base/bear case scenarios in Exhibit 41.