Insights – Europe

by Steven Bell, Managing Director, Portfolio Manager & Chief Economist, Multi Asset Solutions, BMO GAM

Growth in Europe has been disappointing. This time last year, the economy looked like it was booming, but 2018 has seen growth decelerate sharply as a harsh winter took its toll on activity. GDP growth was a meagre 0.3 per cent in the second quarter, a rate that even undershot the beleaguered, Brexit-blighted UK. But it’s far from being all doom and gloom. The eurozone is still growing at an above-trend rate, unemployment is falling and deflation is no longer a threat..

This means that the European Central Bank (ECB) can finally start to wean the region off monetary support by ending its asset purchase programme (quantitative easing) at the end of this year and slowly start to raise interest rates from their negative level, probably sometime in the second half of next year.

The political and economic weakness of the eurozone’s third-largest economy – Italy – is a serious long-term threat. The government’s budget is currently marching in the wrong direction, cancelling the VAT increase and possibly unwinding the pension reform. But let’s not forget that Italy now has a current account surplus. It also has
a cautious, high-saving private sector. And if Europe wants to keep the EU project on the road, it knows it needs to show Italy some love. Indeed, we expect talk without action by the EU Commission to the recent budget proposals by the Italian government.

The Italian coalition government has already realised that it needs to keep its ambitious fiscal plans contained. There may be new elections and a new government in 2019 but we believe that, on balance, investors are being sufficiently compensated for the risks in Italy.

The big issue, in our view, is not the threat from the EU authorities but rather the risk that Italian government debt is downgraded to sub-investment grade. Italy is currently rated two notches above sub-investment grade across the three main ratings agencies (S&P, Moody’s and Fitch). In August, Fitch followed Moody’s in adjusting the outlook for Italian debt to negative, escalating fears that they may follow through with a downgrade. At this juncture, it seems unlikely that either agency would downgrade Italy by two notches, whilst S&P has thus far taken a more sanguine approach, appearing to focus more on long-term dynamics. The 2.4% budget deficit initially proposed by the new Italian government was certainly on the high-end of expectations but it is worth putting this in the context of being well below the 6% number bandied about earlier in the year. The main risk appears to be both a downgrade whilst maintaining a negative outlook, leaving the market nervous regarding further downgrades to sub-investment grade.

Should two of these three agencies downgrade to sub-investment grade, many benchmarked investors (including the widely followed Bloomberg Barclays Global Aggregate) would be forced to liquidate holdings. We can be sure that markets will be volatile but overall, again, we think investors are reasonably well compensated for risk in Italian assets.