As Italian politicians clashed with the European Commission on the 2019 budget, financial markets reacted negatively. This led to more restrictive financial conditions and a decline in consumer and business confidence. As a result, it could well be that the fourth largest economy of the Economic and Monetary Union (EMU) has entered a recession.
Leading indicators are not positive and it is questionable if Italian growth rebounded in the fourth quarter. If not, Italy will have posted two consecutive quarters of negative growth and will have entered a technical recession. On Thursday January 31, 2019 – when the Italian Statistics Agency reports on fourth quarter growth – we will find out if the nation has the dubious honour to become the first EMU member to enter a recession since 2015.
The risks of a recession have been building up
In the third quarter, the Italian economy contracted for the first time since 2014. Real GDP decreased by -0.12% versus the previous quarter and the economy advanced 0.7% year-on-year, making it the weakest annual growth rate since the first quarter of 2015. The decline was mainly driven by lower gross fixed capital formation, but also household consumption decreased. The weakness was broad based across the economy as five out of the seven services sub-sectors recorded a contraction, as did the industrial output.
Since then, most leading indicators have deteriorated. The manufacturing Purchasing Managers Index (PMI) decreased to 49.2 by the end of December, below the neutral rate of 50. The services PMI dropped by almost three points, ending the year just over 50 points. Also, indices measuring consumer-confidence showed a steady decline in the fourth quarter of 2018. Economic sentiment – still above the long term average – weakened too. The deterioration of leading indicators for the Italian economy, coupled with political unrest and volatile financial markets, do not paint a rosy picture for fourth quarter growth.
Broad based slowdown
The slower Italian growth fits into a broader context of the loss of economic momentum in developed markets. Growth in Europe has peaked and is normalizing. Besides that, the economy faced additional headwinds from trade tensions, Brexit uncertainties and volatility on financial markets. Eurozone GDP rose by just 0.2% in the third quarter, down from 0.4% in the prior quarter.
Graph 1: Real GDP qoq growth (in percent). Source: Aegon Asset Management, Eurostat
Italy is not the only eurozone country with negative third quarter growth. Germany – the European growth engine in the past years – clearly lost economic momentum. Lower consumer spending and weaker exports triggered by rising global protectionism resulted in the economy contracting by 0.2% in the third quarter of 2018. Also, specifically hazardous for the German economy, new EU emissions tests turned into a bottleneck for the automotive industry. Outside the eurozone, another major economy slowed significantly as well. The Japanese economy was hampered by natural disasters and shrank 0.6% in the third quarter as the country was struck by heavy rains, a typhoon and an earthquake.
Reality check: no longer living beyond its means
In the past years the Italian economy posted moderate growth, lagging most other developed countries. Still, the county's economy exceeded trend growth in the previous quarters as the country benefitted from the global cyclical upswing and accommodative financial conditions. Now that the global expansion softens and several tailwinds slowly dissipate, Italian growth has fallen closer to its long-term rate. This is close to zero as strong demographic forces put a lid on growth. The decline of the workforce population being a key cause. Estimates show that the working population (between the ages of 15 and 64) is declining to below 30 million by 2040, from 38 million now. This 20% decline of the workforce in a period of only 20 years is in sharp contrast to the previous two decades, when the workforce only declined marginally. Combining the strong demographic forces with a productivity growth that is expected to range between 0% and 1%, the potential growth for the coming years is close to 0%. We argue that this low trend growth will pose major challenges for the Italian economy.
Graph 2: Probabilistic projections of the Italian population: age 15-64 (in millions). Source: Aegon Asset Management, United Nations, World Bank
Even though we foresee challenges for the Italian economy to counteract the negative demographic forces, there are scenarios where the Italian growth could be a positive surprise. In case the business cycle would reignite the Italian economy could benefit, especially since there is sufficient economic slack to support growth. Also, the government could decide to implement reforms, e.g. labour market reforms or anti-corruption measures that could structurally improve economic conditions. Other channels via which the Italian economy could benefit is via long-term favourable financing conditions and a move towards deeper fiscal integration across eurozone countries.
One positive aspect of the Italian economy, is that it now has a large current account surplus. This means that the economy as a whole is a net saver. In that sense, it's not living beyond its means any longer. Also, as the household and corporate sectors don't have large debt burdens, it is primarily the government where debt and deficits are concentrated.
Consequences for financial costs
As mentioned, we think demographic forces will keep Italian growth relatively low for the coming period. These demographic forces are not unique to Italy, as most other developed countries face similar conditions. That said, Italy is in a vulnerable place given the high debt burden that was been building up over the past decades. The combination of low structural growth and high government debt – 131% of GDP – causes a challenging situation for the government to run a budget surplus and drive debt levels structurally lower. Therefore, it is unlikely that Italy can reduce debt levels meaningfully, implying that the country will not comply with the European requirements for an extended time. This is likely to have an impact on many levels, on European politics and policy setting as well as financial markets for the coming period.
Rating agencies are monitoring the situations in Italy closely. In October rating agency Moody's downgraded Italy to the Baa3 profile and changed the outlook from stable to negative. The weakening of Italy's fiscal strength and stalled plans for economic and fiscal reforms, were mentioned as the main reasons for the downgrade, leaving the rating just one notch above sub-investment grade. Italian bond yields and their spread over the equivalent German bund — reflecting the Italian credit premium— hit their highest levels in the post eurozone crisis era last October, after Rome and Brussels disagreed on the proposed budget. Also, investors demand a higher compensation to hold Italian bonds, as they deem the country to be less creditworthy. In case the economic outlook were to deteriorate more, financing costs could increase rapidly as we witnessed last year. Also, further downgrades of the credit rating could prove harmful, especially when Italy would lose its investment-grade rating and easy access to capital markets.