Recession strikes (again) on the Italian peninsula

Italy slipped into a technical recession as real GDP contracted for two consecutive quarters: we observed declines of 0.1% q-o-q in the third and fourth quarter. The economy grew by 0.8% y-o-y in 2018, which is clearly much slower than the 1.6% y-o-y observed in 2017 and substantially weaker compared to peer countries and the Eurozone as a whole (figure 1). Going forward we expect the Italian economy to barely recover at the start of the year and only slightly in the quarters thereafter. In fact a slight contraction in 19Q1 is in the cards. All in all we forecast growth to be flat in 2019.

Istat has indicated that the production sectors agriculture and industry contracted in the fourth quarter, while value added in services stabilized. Regarding the expenditure side, the official breakdown reveals minor increases in household consumption (0.1% q-o-q) and fixed investments (0.3% q-o-q). But, it was net exports that made the largest contribution to real GDP growth. Investments held up better than expected in a quarter troubled by a slowing global economy and policy uncertainty (see box). The most important drag on growth was a decline in inventories. Producers may have been anticipating a slowdown in demand and as such saw less need to keep large inventories. However, computational issues and statistical discrepancies make interpretation of the change in inventories considerably hard.

In the near future we do not see the Italian economy rebounding strongly from the disappointing growth figures observed in the last two quarters of 2018. The coincident indicator of the Italian central bank, which measures the current state of the economy, stands at a five-year low. Overall economic sentiment and consumer confidence maintained its downward trend in the first two month of 2019 (figure 2). And forward looking indicators do not signal any improvement on the production side of the economy in the coming months either: PMI figures signal contraction in the service and manufacturing sector in the beginning of 2019 (figure 3). Moreover, export and production expectations for industry are at the lowest level in over three years (figure 4).

We forecast household consumption to be sufficiently weaker in 2019 than in 2018. In fact for the year 2019 we forecast a minor contraction. Additional demand originating from consumption delayed during the crisis should be exhausted. And employment growth is not expected to reignite in light of weak foreign and domestic demand. Moreover, rising uncertainty about the future state of the economy in combination with historically ultra-low saving rates may lead to precautionary saving and thus the delay of large purchases. Nevertheless, it can be expected that the citizens’ income – as planned by the government – will boost consumption, since it is targeted at those households with the highest marginal propensity to consume. Government intends to make the citizens’ income available only for spending in-store, such that it cannot be saved. However, successful implementation seems easier said than done so some of the citizens’ income may still end up in savings accounts. Moreover, the eligibility of low-income households is likely to increase savings, since they possess an alternative stream of income to save from.

We expect investments to contract substantially during 2019. Overall we think business confidence will remain weak and willingness to invest low, because of slowing demand abroad and at home, and uncertainty about government policy. The policy agendas of the current government parties differ widely and while tensions with Brussels have eased recently, they are set to flare up again later in the year.

The investment climate is also expected to remain under pressure from the strong rise in government bond yields in the second half of last year. It seems that elevated sovereign yields have already impacted credit provision to enterprises. Results of the latest ECB Bank Lending Survey suggest that banks have further tightened their credit standards and the amount they are willing to lend (figure 5). Moreover, we are seeing that the cost of long-term funding for households and businesses is following an upward trend since the current government took office. Admittedly, government bond yields have come down from their peaks last year. It should be noted, however, that yields have not decreased to levels seen before the current government took office (figure 6).

Three weeks ago, the European Commission (EC) lowered its 2019 real GDP growth forecast substantially from 1.2% to 0.2% y-o-y. Importantly, the deal reached between the EC and the Italian government on the deficit target for 2019 was based on the previous growth projection that has clearly proved too optimistic. Therefore, the full set of macroeconomic forecasts, to be published by the EC in May, will likely feature a deficit in 2019 in excess of the target. This may induce the Commission to demand extra budget cuts. Yet given the coalitions’ Eurosceptic view and Five Star’s lower socio-economic voter base, it seems unlikely that the government is going to concede further budget cuts without putting up a fight. This, in combination with more disappointing growth figures, will likely lead to new upward pressure on risk premiums and hence government bond yields. This would likely cause a further tightening of credit standards on corporate loans, less lending and hence less investment (figure 5). On the upside, from Italy’s point of view at least, it now also seems unlikely that the ECB is going to hike its policy rate in the upcoming two years, as our ECB analysts explain here. Moreover, Italian debt seems to be popular among investors searching for returns in this low interest rate climate, as evidenced by recent huge oversubscriptions on bond sales. These factors could help keeping the cost of sovereign debt and consequently of private sector debt in check.

All in all, we expect economic growth to be flat in 2019, with consumption growth slightly and business investment substantially contracting, and net exports contributing more than last year. We believe import growth will slow on the back of weakening domestic demand, while export growth will more or less resemble last year’s weakness. A clear risk in this regard is that of a further escalation of US – China trade tensions and a hard Brexit. As it would lead to a further deterioration of foreign demand.

Overall, our forecast is surrounded by a more or less balanced set of risks, i.e. both upward and downward risks. Not least due to the difficulty in forecasting the impact of the government’s expansionary policies. From the citizen’s income, for example, we expect a positive albeit limited impact on consumption. Yet implementation problems leading to implementation lags may undermine its capacity to stimulate household expenditure this year. At the same time, benefits to the economy could be larger than currently estimated, as households could save less of the additional money than we currently expect. On balance we do not expect a positive impact of the government’s policy set in the near term, mostly due to implementation issues, elevated uncertainty and higher bond yields.

For the long run we even expect a negative impact on growth of the government’s agenda. Mainly because the long-term costs of the government’s plans are bound to be larger than the benefits, implying that somewhere down the line this and future governments will have to cut back on spending or raise taxes to be able to service the ever growing debt pile.

In a previous article, we already wrote about the large negative impact of cancelling the pension reforms on government finances. And we have already explained why not all money spend on the citizen’s income will flow back in the economy. On top of that, the citizens’ income risks being too generous such that it creates a disincentive to work among low-schooled, low-income workers, of whom relatively many reside in the South of Italy. The median-income in the South is only slightly higher than the citizen’s income. In anticipation of or as a reaction to such metrics businesses could be induced to delay or scrap investment plans in fear of cheap labour shortages. Against this backdrop, the citizens income could prove even more expensive in the long term than in the short term. Admittedly, receiving citizen’s income is meant to be dependent on job search. But due to the required major overhaul of existing job centres and the set-up of new ones, we are very pessimistic about the actual implementation of this feature. Implementation problems also apply to the few vague structural reforms proposed by this government, that in essence do have the ability to solve some of Italy’s problems – such as red tape, inefficiency of government investment and the weak judiciary. All in all, we fear that the governments’ current policy set hurts Italy’s growth potential.

Next to the uncertainty surrounding its policies, there is a probability that this government will not finish its term. We believe there is little reason to expect that the coalition is going to break up before the elections though, since this is unlikely to benefit their European Parliamentary election results. Moreover, recent positive signs include an armistice regarding the high-speed rail tunnel to France and Five Star preventing an indictment of Salvini despite their historical opposition to parliamentary immunity. In light of recent drops in the polls, Five Star may be less willing to risk new elections. Meanwhile, Salvini is able to leverage the inexperience of Five Star to his advantage and may see it as an easy-to-control ally going forward.

Nevertheless, tensions may start to rise if growth figures remain weak throughout 2019 and compromises on fiscal policy become necessary. The substantial difference in voter base could make it hard to arrive at new compromises. Also, Five Star seems to have suffered from previous compromises made with the far-right League and Brussels, given its generally green, left-leaning and relatively poor southern voter base. The more radical part of its voter base may be disappointed by the fact that an anti-establishment party opened itself up to making political compromises in the first place. A poor outcome during the European Parliamentary elections may spark serious discussion about the direction of Five Star. This may eventually undermine its willingness to be in a coalition with League or to govern at all. Moreover, on the back of strong European election results, Salvini may feel emboldened to try his luck in a general election and solidify his dominant position at home. Overall, we expect the coalition to stay together in the coming months, but expect the probability of a split to increase after the European elections.