Improving corporate sector … but capital outflows continue

The non-financial corporate sector, in our view, entered a restructuring phase in 2011, and the benefits are beginning to show, given the 30-year low in perceived barriers to exports, an improved perceived competitive position and a mild recovery in pricing power. Also, the trend in foreign direct investment (FDI) shows that there is much less capital leaving Italy than before – but it is still trickling out and, with an intensifying European race to the bottom on corporate taxes, it is not yet time to expect a turnaround. #ChangingEurope

We believe that the dynamics of the industrial sector and the future path of policies affecting it will be the key topics of the upcoming elections, while Euroscepticism, per se, will not. We maintain our view that the market’s favourite hypothetical election outcome (Democratic party + Forza Italia) is the least likely scenario, but this may not be a bad result for the country in the medium term.

Today, we publish our updated country monitoring report for Italy – what we like to call “stress free”, as you should be able to find all the key economic and political trends right there. You are welcome to call us to discuss any questions you may have.

In this report there are several charts that, in our view, well-illustrate the economy’s structural growth status and the upcoming elections. First, there is an accelerating cyclical recovery being signalled by the steady rise in industrial sector confidence, but there is also an even more important recovery in expected pricing power. This is crucial for an economy largely made up of small companies and their tiny balance sheets: pricing power means improved profitability. The trend is not yet high in a historical context, but it is much better than the past six years at least. Secondly, the share of exporters that are signalling barriers to production has dropped to the lowest level since 1985! Not only that, but the bottlenecks in production costs are much less of a problem than ever before (in the past 30 years), and “other” factors, which we interpret as a catch-all category that reflects red tape or productivity differentials, have also dropped to historically low levels. #ChangingItaly

Other important indicators, such as surveys measuring the perceived competitive position of the industrial sector domestically and globally, have shown an improvement, the liquidity at hand seems to have improved, and the number of months of secured production has jumped recently. So, on the back of the balance sheet clean up and the improved Eurozone outlook, it seems that there is a genuine pick-up in the economy.

That said, it is not yet time to rest on any laurels, as much still needs to be done. Looking at the balance of payments, the trend in foreign direct investment (FDI) indeed confirms that Italy is exporting less capital than before but, on the margin, is still seeing a net capital outflow of EUR 11bn in the 12 months to September, and appears still far from actually becoming a net recipient of FDI.

In our view, the state of the industrial sector and its future are at the core of the upcoming elections. Our field studies have shown that the electorate is looking for someone that can prove their competence and humility in understanding and implementing a genuinely strong industrial strategy – to bring back companies and jobs. In our view, on the margin, the party that is perceived to have made the most progress on this front is the highly Eurosceptic Northern League, and the Five Star Movement is well-positioned to cement itself as the most popular party. Support for Berlusconi’s party, Forza Italia, is surprising us on the upside, probably gaining due to the intense friction within the Democratic party seen over the past few months, which may even lead to a change in leadership eventually.

Given the current backdrop, we reaffirm our expectation that the likely winner of the next general election, due sometime in the first half of 2018, will either be a centre-right coalition or a potential broad coalition lead by the Five Star Movement with the (implicit or explicit) support of the Northern League. Both scenarios are likely to have a negative impact on market sentiment around the date of the election, but the fears over the Euroscepticism of Five Stars and Northern League are exaggerated, in our view. The electorate is dissatisfied with the EU – that is true of most other EU member states. However, only a very small share of voters claim to be ready to leave the Eurozone currently – in fact, no sane government could possibly think about making Euro membership its priority before we even know how the European Union will change and what the impact of the UK’s departure will be.

In our view, the focus of the new government will be to find more resources for investment – which are needed desperately to lift the potential growth of the economy – and tax reforms to the benefit of the corporate sector. Both should be welcomed by the market, even under a Five Star government. Whether the implementation of these plans will indeed be genuinely good is a much bigger unknown and will take time to materialise.

Full chartbook is available here

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