Almost everything's easy with hindsight, but hardened cynics really should have seen this coming

Friday 28th September 2018

ref :- " Italy hikes deficit goal, defies EU and rattles markets " , Reuters Markets

Was it really that obvious ? Well yes, probably .... Italy's government is a coalition of two populist parties, populist being the operative word. The Five Star Party (Luigi Di Maio) had promised an increased basic wage and earlier retirement for all, whilst The League (Matteo Salvini) had wooed supporters with pledges of tax cuts. That's a costly mix of policy, and since the raison d'etre of those populist politicians is to be seen to cater for the Italian people rather than adhere to strictures passed down from the EU elite, it was never very likely that those promises would be watered down too much.

Poor old Giovanni Tria, who in truth was facing an impossible task. The Finance Minister was appointed because he is unaffiliated politically and considered suitably responsible fiscally by Brussels, but trying to satisfy the demands of Italy's political masters and still put out a 2019 budget proposal that would be approved of by the EU (and therefore by the markets) was never likely. Long story short, Mr Tria had originally wanted the 2019 budget deficit to be set at 1.6% of GDP, but by last night would have settled for any figure less than 2.0%. Mr Di Maio and Mr Salvini, who had been making market-soothing noises in advance of the witching hour, abandoned the pretence of fiscal conservatism at the last minute and held out for a deficit of 2.4% of GDP -- and 2.4% is exactly what they got.

Now, EU rules state that the deficit-to-GDP ratio should be under the 3.0% ceiling. That being so, we've heard the question asked about why so much fuss is being made of Italy's 2.4% deficit .... particularly since France for example has just proposed a 2.8% deficit of it's own for 2019 ? The answer of course lies in Italy's mountainous pile of total sovereign debt -- about €2.3 trillion (the largest figure in the EU), or nearly 132% of GDP (the second largest percentage behind Greece). Just to service the debt without increasing the total figure would have required a much lower number than 2.4%, and Italy's previous centre-left government had planned for a 2019 deficit ot GDP ratio of just 0.8% with 2020 seeing a balanced budget.

Whether they would have achieved that must remain a moot question, but even the attempt to do so smacks of the kind of institutionally-inspired austerity (to the cost of the common people) that populist parties abhor. No official projections beyond 2019 have yet been offered, but there are suggestions that the unspoken plan of the coalition is to stick to a budget deficit-to-GDP ratio of 2.4% for three years, not just one.

True or not, the proposal for next year alone is bound to bring Italy into some sort of conflict with Brussels, who will be studying the budget next month and to whom Italy had promised to reduce its massive debt. Very likely, it will also cause the ratings agencies (S+P, Moody's) to downgrade their grading of Italian debt .... which of course only exacerbates the situation by raising borrowing costs.

And of course .... and here's the rub as far as we're concerned .... last night's development has very significant market implications. At the time of writing, the FTSEMIB index of shares is 3.9% lower on the morning, with financial sector stocks right in the firing line. Italy's government bonds are being hammered, with the 10yr yield out to 3.24% after trading at 2.70% little over two weeks ago. Yield spreads always offer the best illustrations of problems (or indeed advantages) facing particular nations, and the Italian 10yr yield is 273 basis points above that of Germany's ..... the spread was 235bp seven trading days ago.

So, not a great time to be holding Italian assets. An over-reaction, perhaps ? Well, maybe ..... in the sense that markets generally do over-react in such circumstances. But the EU is yet to have it's say on the budget, and it's not difficult to envisage a scenario where admonishments from Brussels receive an overtly aggressive response from Italy's political leaders , by which we mean Mr Di Maio and Mr Salvini .... and not PM Conti. It's not impossible that we will see buying opportunities in Italian assets ..... perhaps we already are. But this saga has a long way to run yet, and it would take someone a lot braver than us to get involved.

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