RaboResearch - Economic Research

Economic outlook Italy: Coronavirus raises recession risk

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  • In the final quarter of 2019, Italian real GDP contracted by 0.3% q-o-q
  • Domestic demand acted as a drag
  • The first quarter of this year is expected to be better, but another contraction cannot be ruled out
  • The impact of the coronavirus is still very uncertain
  • At this point, we expect the outbreak to depress Italian economic growth by a few tenths in 2020
  • All in all, we think that the economy will be broadly stagnant in 2020 and slightly contract in 2021

2019 ended on a very weak note

The Italian economy contracted substantially in the final quarter of last year (-0.3% q-o-q), see figure 1. The exact breakdown by expenditure components has not yet been published, but we do know that net export contributed positively, while domestic demand acted as a drag. The main reasons for positive net export seem to be the one-off delivery of a ship to the United States and weak import developments. The ship delivery likely also led to a substantial reduction in inventories. From a supply side perspective, value added was flat in the services sector and decreased in industry and agriculture (figure 2).

Figure 1: 2019 ended on a very weak note
Figure 1: 2019 ended on a very weak noteSource: Macrobond, RaboResearch
Figure 2: Manufacturing sector still contracting
Figure 2: Manufacturing sector still contractingSource: Macrobond, RaboResearch

2020 started on a slightly better note

At first sight, the recent bottoming out of the nearly two-year decline in overall sentiment could bode well for the economic outlook (figure 3). Yet with the exception of the retail and construction sectors, all sentiment indicators still point to sluggish growth in the overall services sector and even to a contraction in the manufacturing sector in the current quarter: the respective PMIs stood at 51.4 and 48.9 in January – if the PMI stands below 50, it suggests activity is decelerating. Moreover, all of these surveys were held prior to the plethora of news reports about the coronavirus outbreak, the declaration of a state of emergency by the Italian government and the recent rapid increase of confirmed cases on Italian soil. It is very likely that surveys held since then will paint a gloomier picture. At this point we still forecast economic growth to be broadly stagnant in the first quarter of this year. Yet another contraction and hence a recession cannot be ruled out.

For the year as a whole we forecast slower growth of both final domestic and foreign demand. We expect the slowdown to continue in 2021, with growth of private expenditure even turning negative in 2021. Yet in both years the contribution of inventories will be much less negative than in 2019. All in all, this means that we expect the economy to be broadly stagnant in 2020 and to slightly contract in 2021 (figure 4). Note that at this stage it is still very difficult to forecast the impact of the coronavirus on the Italian economy. It clearly adds downward risks to our outlook and the impact very much depends on how long it will take to stop the outbreak, especially in Italy itself. 

Figure 3: Sentiment points towards stagnation
Figure 3: Sentiment points towards stagnationSource: Macrobond, RaboResearch
Figure 4: Economy in the doldrums
Figure 4: Economy in the doldrumsSource: Macrobond, RaboResearch, NiGEM

Domestic demand is expected to slow

We expect growth of private consumption and housing investment to slow over the coming two years. For one, because households’ propensity to save is high. Second, despite some accommodative fiscal measures such as a cut in the labor tax wedge and the basic income scheme that was introduced in the course of last year, we expect more muted disposable-income growth over the forecast horizon. This is due to lower real wage and employment growth. Real wage growth is tempered by slightly increasing inflation and subdued nominal wage growth, partly because several important sectors have still not concluded collective wage agreements. Meanwhile, job creation is hampered by the weak economic outlook, deteriorating corporate profits (figure 5) and reduced spare capacity in the labor market (figure 6). Third, the ageing and shrinking population also puts pressure on private spending. Finally, it is still difficult to assess the exact impact of the outbreak of the coronavirus in Italy and subsequent quarantine measures, but Covid-19 poses undeniable downside risks to the Italian economy. We will elaborate on the impact of the virus at the end of this publication. 

Figure 5: Deteriorating profit margins hamper investment and employment growth
Figure 5: Deteriorating profit margins hamper investment and employment growthSource: Macrobond, RaboResearch
Figure 6: Still quite some spare capacity left in the labor market, but less than in the past
Figure 6: Still quite some spare capacity left in the labor market, but less than in the pastSource: Macrobond, RaboResearch
Figure 7: Policy uncertainty has significantly declined, but don’t get too comfortable just yet
Figure 7: Policy uncertainty has significantly declined, but don’t get too comfortable just yetSource: Macrobond, RaboResearch

We forecast weak growth of business investment in 2020 and a decline in 2021, on the back of contracting corporate profits and bank lending, decreasing capacity utilization, weakened order books, and a rather bleak outlook for both domestic and foreign demand (see below, figure 11). Moreover, while policy uncertainty has significantly declined over the past year (figure 7), we should be under no illusions that the political and policy outlook is suddenly very promising. Hence in our view, the reduction in policy uncertainty should provide limited relief for business investment.

Policy uncertainty is here to stay

Figure 8: The (radical) right heads the polls
Figure 8: The (radical) right heads the pollsSource: Macrobond, RaboResearch

Despite the many frictions between the governing parties, i.e. Five Star, PD, Free and Equal and Italia Viva, currently we do not expect early elections this year. According to the polls the governing parties stand to lose big time if elections were be held right now: the radical-right led by Matteo Salvini could win an absolute majority in parliament, while Five Star would shrink by at least half and former PM Renzi’s Italia Viva would struggle to be relevant (figure 8). The prosecution of Salvini over charges of abuse of power and illegal detention of migrants back in 2019 are unlikely to harm his ratings, as his popularity is based on his anti-immigration stance. He could face 15 years in jail if convicted, but given the very lengthy nature of trials in Italy, a verdict could take years.

Another reason why the current government will try to prevent early elections is that the coalition is committed to alter the electoral law to the disadvantage of Salvini’s Lega party and to reduce the number of lawmakers in parliament. The latter proposal has broad support among citizens and will likely be voted on and passed in a referendum late March. Finally, early 2022, parliament will elect a new President; which is before the official term of the current parliament ends.

While the government’s sticking together can be viewed as a positive, given the high uncertainty early elections and subsequent Lega win would bring, it is unlikely that the economy will benefit much from the current government. Given the large internal divisions, the government’s very weak majority in the Senate and the busy regional election calendar in spring, we expect little meaningful legislation to improve the country’s very weak longer-term growth perspective and public finances.

At the same time, and for the very same reasons, the risk of a government crisis leading to early elections remains considerable. So all in all, we are of opinion that policy uncertainty remains large over the forecast horizon.

Government finances are set to weaken

Based on the current budget plans and economic outlook, the public budget deficit is expected to increase slightly this year and come in close to 2.5% of GDP. The debt-to-GDP ratio is also set to rise a touch to around 137% of GDP. The European Commission warned Italy in November last year that it risks significantly deviating from its obligations under the European budget rules. It is highly likely that the outbreak of the coronavirus in Italy will further worsen public finances. To the extent that it will, the European Commission is expected to cut Italy some slack and grant more flexibility. Yet it is unlikely to prevent Brussels from asking Rome to take measures for deviations not caused by the virus.

If the current government is still in place in spring, when the European Commission is expected to ask Italy to alter its fiscal policy, the coalition is likely to ultimately broker a deal with Brussels to prevent a clash as seen end 2018. This is provided that the governing parties still lag substantially in the polls. If one of the parties were to benefit from early elections instead, the story changes. In addition, in the unlikely event Lega is heading a government at that time, also more fireworks between Rome and Brussels should be expected.

In the meantime, the ECB’s expansionary monetary policy and the search for yield by private investors are putting a lid on bond yields, which are at record lows (figure 9). Yet with a rapidly ageing population and a potential growth rate close to zero, it is difficult to see how Italy’s public finances can remain affordable and sustainable in the long term without a change in fiscal policy and reforms to enhance productivity. 

Figure 9: 10-year bond yields near record-lows, yet bund spread is still a touch higher
Figure 9: 10-year bond yields near record-lows, yet bund spread is still a touch higherSource: Macrobond, RaboResearch
Figure 10: Rapidly ageing population
Figure 10: Rapidly ageing populationSource: Macrobond, RaboResearch

Foreign demand faces many headwinds

The Italian external sector is facing headwinds as well. Italian export growth over the forecast horizon is hampered by the coronavirus, slowing global demand and more specifically by weakness in important trading partners (figure 11), a run of the mill recession in the US end-2020 and a Brexit early 2021 that will push the UK into recession. Trade tensions between the US and China and the US and the EU, do not help either.

Following the phase 1 deal between the US and China tensions have eased somewhat, but we expect them to flare up again in 2021. With respect to the EU, the US has so far only hiked import tariffs on a relatively small package of European goods. Although this harms producers in certain industries, the direct macroeconomic impact on the Italian economy is small. What’s more worrying is the US threat to hike tariffs on European cars to 25% (figure 12). While we do not expect the US to live up to this threat in the foreseeable future, we cannot entirely rule out the risk. We have calculated that such a hike could reduce Italian car production by 5% and shave off a couple of tenths of Italian GDP growth. 

Figure 11: Important trading partners face substantial headwinds over the forecast horizon
Figure 11: Important trading partners face substantial headwinds over the forecast horizonSource: Macrobond, IMF dots, NiGEM, RaboResearch
Figure 12: Already struggling car sector is recurring subject of Trump threats
Figure 12: Already struggling car sector is recurring subject of Trump threatsSource: Macrobond, RaboResearch

Economic risk related to coronavirus

According to our initial estimates, the coronavirus will shave off a few tenths of Italian economic growth in 2020. We expect the virus to depress growth in the first half of this year, and growth to partially rebound in the second half.

In our baseline scenario the situation will stabilize quickly in China and the international spread remains limited to a few, notably Asian, countries. We expect the virus to have a substantial negative impact on Chinese activity in the first half of the year, after which growth should partially rebound in the second half. In this scenario, the virus will have an impact on the Italian economy mainly via trade with China and Chinese tourist inflows.

With the rapid surge of confirmed COVID-19 cases on Italian soil in the past few days and subsequent emergency measures by the government, downward risks to the Italian economy have increased. That said, the spread of the virus in Italy is still relatively contained when compared to China and some other Asian countries and damage is still hard to assess at this stage.

We continue to monitor developments closely and will adjust our baseline if deemed necessary. In any case we are currently conducting more thorough calculations of the impact in different scenarios and will present our results shortly.

Below we will elaborate on the main channels via which the coronavirus is expected to have an impact on the Italian economy.

Limited but non-negligible exposure to China and rest of Asia

Around 3% of Italian goods export value goes directly to China (figure 13) and about 7% goes to other Asian countries that will be severely impacted by China’s slowdown. Even though Italy’s manufacturing sector is more exposed to a slowdown in China than these figures alone suggest, especially due to its supply chain integration with Germany’s manufacturing sector, Italy’s overall exposure to China is limited. Certain sectors, like the car sector, are much more vulnerable, though: 10% of all Italian cars export goes to China (OEC data) and we already know that Chinese car sales shrank by 25% y-o-y in January and 92% y-o-y in the first two weeks of February.

Import dependence is larger

Due to China’s lockdown, imports of Chinese goods are hampered as well. This could hurt sales of retail stores that sell Chinese consumer goods and, possibly more importantly, domestic industrial production that depends on Chinese intermediate goods. About 5% of Italy’s intermediate imports for industrial production come from China. If we include raw materials this figure is as high as 8% (figure 14). The CEO of car manufacturer Fiat already warned early February that production at one of its European Fiat factories could be at risk in a few weeks’ time. Hence the coronavirus seems to be adding troubles to the already struggling car sector in Italy. Italian car production shrank by almost 20% over the past two years (figure 12). 

Figure 13: China within top ten trading partners, but exposure is limited
Figure 13: China within top ten trading partners, but exposure is limitedSource: Macrobond, RaboResearch
Figure 14: In Italian industry, 8% of intermediate input imports comes from China
Figure 14: In Italian industry, 8% of intermediate input imports comes from ChinaNote: Industry includes mining, manufacturing and utilities
Source: RaboResearch, Macrobond, OECD

Tourism activity likely to take a hit

Next to trade in goods, growth in the tourism sector will also slow. Roughly half of tourism income comes from foreign tourists, the other half from Italian travelers. Given the recent surge in cases in Italy itself, not only the Chinese tourists - who make up 2.5% of all tourist arrivals at tourist accommodations - are expected to stay away. Certain countries, like the Netherlands and the US, have already issued travel warnings for example. And anecdotal evidence suggests that bookings at tourist accommodations across the country are already being canceled. Travel bans to and within Italy for employees of both foreign and national companies do not help either. Given that tourism contributes 13% to Italian GDP, weak tourism activity can have a rather substantial impact on GDP growth.

Suppressed domestic activity

So far, the spread of the virus in Italy is still relatively contained, but it will have some negative impact on Italian economic growth. Activity in the dozen quarantined towns in the North of Italy has come to a halt and Italy’s economic capital Milan - accounting for 10% of Italian GDP - has also essentially turned into a ghost town. Although not quarantined, restaurants and bars are empty and schools and tourist attractions are closed. Furthermore, in many Northern cities, companies are cutting back client visitations and employees are being asked to work from or stay home.

Figure 15: Italian stock market takes a deep dive, but index is still above 2019 level
Figure 15: Italian stock market takes a deep dive, but index is still above 2019 levelSource: Macrobond

For now we expect somewhat weaker retail sales – after initial hoarding -, hospitality income, production and turnover. Yet no major supply chain disruptions. That said, with most confirmed cases in the regions Lombardy and Veneto, which are in the heartland of Italian industry and together produce about one third of Italian production, risks clearly hinge to the downside. Not only for the Italian economy, but also for closely linked industries in other Eurozone countries such as Germany. Stock markets all over the euro area have lost all of this year’s gains upon the news in Italy (figure 15).

To conclude

In short, at this stage we expect the coronavirus to depress growth by a few tenths in 2020, possibly pushing the economy into recession. Certain industries like the car and the hospitality sector are expected to take a more substantial hit. It goes without saying that the longer China’s economy is paralyzed, the more global trade will suffer and the more Italy’s trade with countries other than China will also be dampened.

Moreover, if quarantine measures in Italy prove ineffective or if such containment measures are extended to other Italian regions, this could stifle the domestic movement of products and disrupt both national and international supply chains. That, in turn, could further slow the economy. While the impact of the recent surge in cases is difficult to assess at this time, it clearly tilts the risks for the Italian economy to the downside.

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