Italian GDP fell -0.2% q/q in Q4, its second straight quarterly contraction, meeting one popular definition of a recession.[i] With this news come fears the eurozone’s third-largest economy is a bellwether for the entire bloc. Yet a look under the hood suggests this is a hasty judgment. While Italy and the eurozone share some headwinds, some unique local factors seemingly made Italy more vulnerable. With those headwinds likely to fade, we expect economic reality to soon top today’s dreary expectations, delivering eurozone stocks plenty of positive surprise.
Q4’s contraction builds on Q3’s -0.1% q/q dip.[ii] Although GDP details remain scarce, data suggest weakness was concentrated in fixed investment, manufacturing and exports. Weak fixed investment likely resulted from spiking Italian interest rates during autumn’s budget standoff with the EU. Rising rates seem to have temporarily deterred borrowing—and business investment, which credit growth often drives. The budget spat drove 10-year Italian government bond yields up to 3.6% in October from 2.8% in September.[iii] While 3.6% isn’t exactly lofty, the sharp spike may have given borrowers pause, especially since it looked sentiment-driven and likely temporary. In that case, businesses are likely to wait for rates to subside before locking in years’ worth of interest expenses. It is simply sound financial management to take a wait-and-see approach before making a long-term decision. With Italy’s budget standoff now over and rates lower, firms can unleash business plans, borrowing and investment they shelved last autumn. The result may just be some economic activity pushed from late 2018 to early 2019.
Italy also felt a pinch from a regional issue: new EU emissions standards. These likely impacted industrial production, which fell in all three months in Q4, dropping -0.8% m/m in December. Ditto for deteriorating manufacturing purchasing managers’ indexes (PMIs).[iv] The new standards took effect in September, creating production hiccups as automakers worked to adapt. For example, Volkswagen estimated higher standards would interrupt production of 200,000 – 250,000 vehicles in 2018’s second half.[v] While Germany is more known for auto production and felt a related GDP hit in Q3 (as did Sweden), Italy is also vulnerable as many Italian manufacturers supply German carmakers. Auto sales figures show consumers front-ran the new regulations, with sales jumping before the rules took effect and falling through yearend. (Exhibit 1) This is normal when changes like this take effect, and it usually proves short-lived as everyone adapts to the new regime.
Exhibit 1: New Passenger Car Registrations
Source: FactSet, as of 1/18/2019. New passenger car registrations, January 2014 – December 2018. Sweden’s effect is magnified by an additional sales tax designed to promote electric cars.
Export weakness, the last main drawback, was a global headwind seemingly stemming from weak private sector demand in China. While many blame tariffs, it seems more likely a result of China’s 2018 crackdown on shadow banking—lending occurring outside the traditional banking system. This arena mostly finances small and medium sized enterprises (SMEs). While credit kept flowing from banks, they lent primarily to large state-owned enterprises that didn’t need it as much versus picking up the slack from shadow lenders. Hence, the government’s crackdown disproportionately affected private firms. This isn’t good news, as China’s millions of small private businesses are its primary growth engine. But there is light on the horizon, as Chinese officials have passed several fiscal and monetary stimulus measures in recent weeks, aimed primarily at SMEs. As those start bearing fruit in the coming months, they should help bolster demand.
While Italy’s weak areas garner the most headlines, the bulk of its economy—services and consumption—appears to be holding up better. Whereas fixed investment is less than 20% of Italian GDP, consumer spending is about 60%.[vi] Retail sales—though by no means a perfect proxy for consumer spending—accelerated from a 0.2% m/m October gain to 0.7% in November.[vii] We don’t have figures for Q4 services consumption—almost two-thirds of total household spending—but the Italian National Institute of Statistics described last quarter’s service sector production, nearly four times the size of Italy’s manufacturing sector, as “substantially stable.”
Beyond Italy, most of the eurozone is growing. Although folks often fear smaller regional contractions pull everyone else down, we see little evidence of that in the eurozone today. On the contrary, nations reporting thus far appear resilient to Q4’s regional challenges. In its full-year GDP estimate, Germany’s statistics department estimated GDP held steady or grew in Q4, rebounding from Q3’s contraction. Its composite PMI—combining manufacturing and services—strengthened to 52.1 in January (readings above 50 indicate expansion), suggesting growth continues.[viii] Meanwhile, in Q4 reports garnering fewer headlines, French GDP grew and beat expectations. Spanish GDP grew 0.7% q/q—up from Q3’s 0.6% and ahead of estimates.[ix] Combined, their GDPs far outweigh Italy’s. The eurozone’s composite PMI was 51.0 in January—signaling growth on the Continent is chugging along.[x] The media’s focus on Italy while ignoring a brighter bigger picture is a classic example of sentiment underrating reality, in our view.Italy may have fallen into a shallow recession, but the evidence argues against a prolonged downturn in the country or the eurozone. What matters for investors isn’t what is past—and already priced into forward-looking markets—but whether the future is brighter than people fear. With expectations grim, it wouldn’t take much to positively surprise investors and boost stocks. In our view, that is the likely path forward.
[i] Source: Istat, as of 1/31/2019. Q4 2018 Real GDP.
[ii] Source: Istat, as of 1/31/2019. Real GDP, Q3 and Q4 2018.
[iii] Source: FactSet, as of 2/5/2019. 10-year Buoni del Tesoro Poliannuali (BTP) yield, 9/18/2018 and 10/19/2018.
[iv] Ibid. Italy industrial production, October and November 2018.
[v] “VW Says 250,000 Cars Could Be Delayed by New Testing Rules,” Andreas Cremer and Jan Schwartz, Reuters, 6/8/2018.
[vi] Source: FactSet, as of 2/5/2019. Gross Fixed Capital Formation and Household Consumption Expenditures as a percentage of GDP, Q3 2018.
[vii] Source: Istat, as of 1/10/2019. Retail trade index, October and November 2018.
[viii] Source: IHS Markit, as of 2/5/2019. German Composite PMI, January 2019.
[ix] Source: Eurostat, as of 2/6/2019. Spain, real GDP growth rate, Q4 and Q3 2018, respectively.
[x] Source: IHS Markit, as of 2/5/2019. Eurozone Composite PMI, January 2019.
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