Daryl Jones is director of research at Hedgeye Risk Management, an investment research firm based in New Haven, Conn.
Europe’s sovereign debt woes will be high on the agenda as the G20 countries continue their meetings today in Mexico. For much of the past two years, the focus has been on Greece and Spain. In the coming months, though, we expect Italy to become a more significant concern than either of those countries.
With gross domestic product (GDP) of $2.2-trillion (U.S.), the Italian economy is more than 20 per cent larger than the combined economies of both Greece and Spain, so it has much more influence than those nations on the future of both the euro zone and the global economy.
In the accompanying chart, we compare the 10-year yields on Spanish and Italian sovereign debt over the past year. Italian yields hit cyclical highs last fall and then started a gradual decline on the back of austerity programs passed in Italy. Over the course of the past month, yields have once again accelerated upward and are tracking those of Spain.
The most recent indicator of how the market perceives Italian credit worthiness was the auction for Italian three-year debt last Thursday. The auction was successful in that the debt sold. More disconcerting was the fact that it did so at a yield of 5.3 per cent. This was a 36 per cent increase in yield from just a month prior. To the extent this trend continues, Italy will effectively be shut out of sovereign debt markets, except at usurious rates.
Two key issues are driving the acceleration in Italian yields. First, the market is signalling it does not believe that Italian Prime Minister Mario Monti’s austerity measures will get passed and improve the Italian fiscal outlook. Second, there is the burden of broader European bailouts, such as the recently announced aid for the Spanish banking sector. Euro zone members are expected to participate in these bailouts and the cost will further strain an already precarious Italian government balance sheet.
To make matters worse, economic stagnation in Italy shows no signs of abating. GDP growth has been negative for three quarters in a row and contracted at a 0.8 per cent clip in the first three months of this year. Meanwhile, unemployment climbed to a seasonally adjusted 9.8 per cent, the highest level since 2000. Italy’s ability to grow its way out its debt balance is dubious, at least in the short term.
Compared to many of its peers, Italy has an almost reasonable deficit that is expected to come in around 3 per cent of GDP this year. The core issue with Italy is that its accumulated debt stands at more than 120 per cent of GDP. Not only does this debt create a headwind for economic growth, but it also requires the need to constantly refinance it with new bond issues. These refinancing requirements are likely to be the catalyst that pushes Italy over the sovereign debt precipice.
In aggregate, Italy has €1.9-trillion in outstanding government debt versus €720-billion in outstanding debt for Spain. Even more concerning is Italy’s repayment schedule. According to our research, Italy has an accelerated repayment schedule over 2012 of more than €255-billion. The collective repayment requirements for the remainder of 2012 and 2013 for Italy are more than €515-billion.
Many pundits have highlighted the fact that Italy is not Spain or Greece. This is true. In fact, Italy has more than twice as much debt to sell than both of those countries combined over the next 18 months. This massive backlog of Italian debt for sale is likely to be the fundamental inflection point that shifts the eye of the European sovereign debt storm from Greece and Spain, to Italy.