• GB Davis

Will Italy be this Cycle's Lehman Moment? - 5/8/20

Moody's took no action on Italy or Greece today.  (Note: Moody's Sovereign Release Calendar designates two dates for the potential release of both solicited and unsolicited sovereign credit rating actions, in accordance with EU Regulation 462/2013 ("CRA3"). It includes sovereign issuers that are covered by a Lead Analyst based in the EU, as required by CRA3 and, in order to provide greater market clarity, it also includes EU sovereign issuers that are covered by Lead Analysts based outside of the EU.)


Our view in a Nutshell is, very generally: 



IF:


  1. the EU or ITA does not "snap back" in Q3 (a "V") - and - that pressure puts increased pressure on the 2020 ITA Budget, creates domestic political infighting and discussions of leaving the EU - and domestic economic weakness lingers into 2021 - then all bets are off.

  2. a resurgence of COVID19 and/or Lockdown, including Export markets in continental Europe and abroad, constraining the ITA economy, Consumption and the like - then all bets are off.

ITA would be downgraded, their costs of funding would rise, their credit spreads could blow out and not be contained and it would be quite a sovereign default - it could be the Lehman moment of this cycle - imagine if they are gently pushed in that direction by numerous parties.


Here is Moody's from a couple of weeks ago:


In Moody's view, Italy entered the coronavirus crisis with weaker credit fundamentals than most other euro area countries, having recorded weak growth over the last decade and very high public debt levels. Credit pressures could intensify if Italy's economic recovery were to be delayed until 2021 or if it is much weaker than expected, despite government and central bank measures. Pressures would also build if the government failed to present a credible fiscal strategy to repair the public finances or if a lack of consensus at the EU level were to weaken policymakers' credibility and lead to higher borrowing costs.

It would be harder to see Italy's rating being unaffected should we come to the conclusion that debt will remain very high over the medium term, growth will remain low, and policymakers will remain unable to meaningfully address underlying problems. That would most likely place too much weight on euro area policymakers continuing to succeed in keeping Italy's yields at affordable levels even as a broader recovery takes hold  employment, bankruptcies and bank lending could give early indications if the government measures are bringing the intended results


This outcome assumes a contingent liability shock and the crystallization of a part of the credit guarantees extended by the government (which amount to a total of €340 billion).1 In that scenario, the primary balance would moreover remain in deficit by 2023, with a consequent negative impact on interest rates. 


A key conclusion we draw from the above sensitivity analysis is that the Italian government will have little choice other than to embark on a repair of its public finances, alongside meaningful structural economic reforms, over the coming years. Italy has managed to do so in the past: In 2011/2012, the Monti government managed to reduce the budget deficit by around 30% between 2010 and 2012 via strict control of primary spending and some tax increases. Notably, however, those measures were taken by a 'technocratic' government able to act, albeit only for a short period, outside the bounds of political rivalry 


Thirdly, Italy's rating could come under more intense pressure if confidence that Italy's debt would remain affordable were to diminish. For example, if euro area policymakers were unsuccessful in commanding the confidence of investors in their ability to achieve the consensus needed to engineer rapid recovery from the crisis while supporting weaker members, leading to a material rise in borrowing costs for those weaker members 


Another episode of heightened political uncertainty and rising anti-EU political rhetoric could bring back concerns over Italy's longer-term willingness to remain in the euro area, similar to the situation in 2018 when two euro-sceptic parties, the Lega and the Five Star Movement, formed a coalition government. Both parties have been losing support according to recent opinion polls, but at the same time the scepticism toward the EU among the wider population has been increasing; there currently is no longer a clear majority among the Italian population in favour of EU membership 


The government's cost of issuance stood at 0.93% on average in 2019, compared to 3.61% in 2011, thus the current pandemic crisis is not comparable to the euro area sovereign debt crisis. Interest spending on the public debt has declined from a peak of €83.8 billion in 2012 to around €60 billion in 2019, despite the increasing debt load over this period. We expect Italy's interest spending to decline further this year and probably also next, because of the ECB's support but also because a larger part of the funding will probably be raised in the form of short-term debt. Back in 2012, outstanding T-bills were €151 billion or over 9% of total government debt; the comparable numbers are €118.5 billion and 5.9% as of March 2020. 

NEXT UP:


  • The Global Unlocking & Social Distancing Impact on Consumption of Goods & Services

  • Continued Unemployment Issues

  • The Prospect of "Hot Spots" and COVID19 resurgence

  • 2Q Earnings Season (mid-July through mid-August) - where the horrific numbers shall hit

  • Funding GAPS

  • Downgrades

  • Bankruptcies

  • Commercial Real Estate - Retail, Hotel and even Office at this point (remote working)

All before next PIC Season (Pneumonia, Influenza, COVID19, winter 20/21) - a new acronym to get used to - and, yet, no vaccine.


So - as merely a spectator - we see risks pointed to the ITA economy not bouncing back in 3Q and lingering economic weakness into 2021 - in which case, we'll watch to see what happens to Credit Spreads (their own (abs), and the ITA-GER spread), CDS, political rhetoric in the block, and domestically there (including each of the flaring or flaming of EU separatist tendencies), and we watch the Agencies, and their Actions - the odds tilt towards an ITA sovereign default - and in such case, that could be this cycle's Lehman Moment.

Who said MACRO can't be exciting?

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