Political uncertainty in Italy and the fall of Mariano Rajoy in Spain, activity in the main emerging countries remains solid

Macro Highlights - 6/5/2018

In short
  • In Italy, the swearing-in of a coalition government on 1 June ended a week of political twists. Uncertainty could nevertheless persist, which would fuel volatility in sovereign yields
  • In Spain, Pedro Sanchez took over from Mariano Rajoy after a no-confidence motion was voted against the former president. This change in the presidency of government should not modify the country’s economic outlook
  • Leading manufacturing indicators for the main emerging economies suggest their economic expansion would continue
  • Growth in China remains dynamic in both the manufacturing and services sectors. India would continue its economic recovery in 2018, while the political uncertainty in Brazil is affecting the leading indicators

In Italy, a Five-star movement/League coalition government was sworn in, easing political uncertainty, at least in part

The key event of the week was the rise  in political uncertainty  in  Italy. Uncertainty was particularly high  following the announcement on 27 May of Italian President Sergio Mattarella’s opposition to Giuseppe Conte's proposal of a coalition government, which included the appointment of eurosceptic Paolo Savona as economy minister. This decision prompted Conte, who had been given the mandate as prime minister by the coalition of the Five-Star Movement and League parties to form a government, to step down. As a result, uncertainty increased over whether new elections would be held, when on 28 May Mattarella asked Carlo Cottarelli, a former IMF official, to form a temporary government, who then was not able to win the vote of confidence in the Italian parliament.

A solution to this political sclerosis was nevertheless found on 31 May, with the coalition proposing a new government led by Conte and that was accepted by Mattarella. In this new formation, pro-euro Giovanni Tria notably becomes economy minister, Paolo Savona the European affairs minister, and Enzo Milanesi, a partisan of Europe, will be foreign minister.

The announcement and swearing-in of this government on 1 June favoured an easing of Italian sovereign yields, which had previously risen sharply. Thus, on Friday 1 June, the 2-year and 10-year government yields closed at 1.07% and 2.69%, respectively, after having reached levels of 2.77% and 3.16% on 29 May. They nevertheless remain far above their levels of 30 April 2018, which were -0.30% for the 2-year and 1.79% for the 10-year. Moreover, the spread between the Italian and German 10-year yields, which narrowed from 290bp on 29 May to 230bp on 1 June, remains wider than its end-April level of 123bp.

Analysis and implications:

  • „The swearing-in of the new government in Italy on 1 June reassured markets because it removed the risk of new elections. Political and economic uncertainty could nevertheless still persist while the viability of the coalition of the Five-Star Movement and the League needs to be confirmed and the government is planning measures that could deteriorate the country’s public finances.
  • Thus, we maintain our forecast of a deceleration in Italian GDP growth in 2018 and 2019, as a result of weaker growth in corporate investment (due to the high uncertainty and the risk on the banking system) and a slowdown in household consumption (with an erosion of real purchasing power with the rise in oil prices in a context in which the unemployment rate should drop only slightly).
  • The persistence of this uncertainty could maintain volatility in Italian sovereign yields and lead them to experience temporary upwards phases. However, according to our analysis, the rise in sovereign yields should be contained as:
  • Firstly, Italian debt is held for the most part by Italian residents (with 67.7% of outstandings, of which 16.3% for the Bank of Italy as part of the ECB’s asset purchase programme) and residents of other eurozone countries (27% of outstandings). These are primarily long-term investors who keep their securities to maturity. They are thus unlikely to hastily sell off their Italian bonds as this would expose them to significant losses that they would avoid by keeping these securities in their portfolios.
  • Secondly, the ECB, as it has shown in the past, could make an exception to its bond purchase country allocation rule to temporarily limit the rise in the bond yields of certain countries. If the Italian government were to confirm its attachment to the euro and its compliance with European rules, the ECB could increase its purchases of Italian debt if necessary. Moreover, the ECB would maintain this ability to avoid a rise in sovereign yields even when its asset purchase programme comes to an end, as it has not determined strict rules for the reinvestments it will make beyond that date, which are substantial (for example, they will amount to EUR172 billion between May 2018 and 2019).
  • Lastly, while Spanish and Portuguese yields could endure upwards pressure at the same time as Italian yields, this pressure should be limited. The significant improvement in economic fundamentals in Spain and Portugal is likely to reduce the risk of contagion. Moreover, the ECB could increase its purchases of Spanish and Portuguese debt if necessary.

In Spain, Pedro Sanchez takes over from Mariano Rajoy following a no-confidence motion against the former president

The no-confidence motion against the former head of government, Mariano Rajoy, was voted on 1 June by a majority of 180 out of 350 members of parliament. Mr Sanchez, Secretary-General of the Spanish Socialist Workers' Party (PSOE), who had filed the no-confidence motion against Rajoy, will take over as the new President of the Spanish government.

This event did not result in any movement of concern on financial markets. While investor worries had also been alleviated by the announcement of the swearing-in of the new Italian government (see above), Spain’s sovereign 10-year yield fell 6bp to 1.44% on 1 June, and the IBEX 35 equity index closed on a 1.8% rise.

Analysis and implications:

  • As Mr Sanchez made the commitment on 31 May to maintain the 2018 budget previously adopted by the Spanish parliament, and to comply with the budget deficit levels defined in agreement with the European Union, Spain’s economic outlook is not likely to change.
  • Moreover, although Sanchez has stated he wishes to reopen dialogue with the Catalan separatists, he is opposed to the region’s independence. As a result, the change in the President of the Spanish government is unlikely to raise the risk of a separation of Catalonia, but could, on the contrary, ease tension between Madrid and Barcelona.
  • A source of uncertainty could, however, stem from early elections (the next elections are in 2020) as the PSOE, which holds just 84 seats in parliament, could have difficulties in obtaining the majority required for adopting new laws. However, recent polls indicate that if elections were to be held in the near future, the liberal Ciudadanos party would be the favourite, which would ensure a continuity of the economic policy.
  • Thus, we maintain our economic scenario for Spain according to which GDP growth, which has been above 3% for the past three years, could slow slightly in 2018 and 2019, notably due to a deterioration in households’ purchasing power. However, exports are likely to continue to buoy activity thanks to the improvement in their cost competitiveness and the real estate market could pick up. We thus continue to forecast that Spanish GDP growth should remain above the overall eurozone average.

The leading manufacturing indicators of the main emerging countries continue to point to expansion

The main emerging economies published their leading manufacturing indicators for May. Not only China but Brazil and India too published numbers above the 50-point mark, signalling economic expansion.

In China, while the manufacturing indicator published by Caixin remained stable over the month at 51.1, t he official indicator increased to 51.9 vs. 51.4 the month before. This improvement concerned most components making up the indicator. New orders thus came in at 53.8, while input and output prices recorded a more significant rise, to 56.7 and 53.2, respec tively. These trends were also confirmed for the Caixin indicator. Large-sized companies, which are more sensitive to the policy adopted by the Chinese authorities, experienced a comparatively stronger rebound than small and medium-sized companies. This observation may reflect Beijing’s current policy that is more in favour of growth – and temporarily less focused on control of the credit markets and deleveraging the country – in order to achieve growth of close to 6.5% in 2018. This possible easing of pressure on the control of financial risks had been suggested in the quarterly report of the People’s Bank of China (see our Weekly of 22 May 2018). Moreover, the positive economic momentum in China is also reflected in the official leading indicator for services activities, which showed a slight improvement, from 54.8 to 54.9, suggesting a continuation of China’s growth trend since the start of 2018.

In India, despite the slight drop in the leading manufacturing indicator, from 51.6 to 51.2, the component relating to future production remained at a high level, suggesting the relative confidence of industrial groups following the shocks of the demonetisation of 2016 and the introduction of a Goods & Services Tax in 2017. This element suggests a continuing rebound in activity in India after a relatively disappointing 2017.

Lastly, in Brazil, the leading manufacturing indicator published by Markit recorded a decline. It was down at 50.7 from 52.3 in April. This trajectory, which can be observed both for new domestic orders and for new export orders, can be explained by the political uncertainty ahead of the presidential elections to be held in October. The uncertainty surrounding the outcome of the polls, for which no favourite has yet to clearly stand out, would weigh on the country’s economic activity and could weaken its external position, especially as little progress has been made with respect to the reforms required to ensure the fiscal consolidation.