05 Oct 2018 3 min read

Could Italy’s dolce vita be at risk?

By Hetal Mehta

Fears over Italian debt levels have risen sharply following the announcement of the country’s three-year fiscal plan. Should investors be worried?

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Italy has been on our radar for some time. We’ve covered the rise of populism in the country, its debt situation and the challenges it presents for the European Central Bank. And just the week before last, I was on CNBC discussing the significant tail risks in the country. 10 days can be a long time in both politics and investments, and now Italy’s making front page headlines again.

Res. no. Proposal LGIM vote direction LGIM rationale
1a Elect: Bezos Against (against management recommendation)   A vote against is applied as LGIM expects a board to be regularly refreshed in order to maintain an appropriate mix of independence, relevant skills, experience, tenure, and background
1f Elect: Huttenlocher Against (against management recommendation)   A vote against is applied as the director is a long standing member of the Leadership Development  & Compensation Committee which is accountable  for human capital management  failings.
1g Elect: McGrath Against (against management recommendation)   A vote against is applied as the director is Chair of the Leadership Development  & Compensation Committee which is accountable  for human capital management  failings. Remuneration: Escalation: A vote against is applied as LGIM has had concerns with the remuneration policy for the past year.
5 REQUESTING A REPORT ON RETIREMENT PLAN OPTIONS Against (in line with management recommendation)   A vote AGAINST this resolution is warranted as The Department of Labor is finalizing rules on how ESG factors should be considered by fiduciaries. 
6 REQUESTING A REPORT ON CUSTOMER DUE DILIGENCE-assessing Amazon’s customer due diligence process to determine whether customers’ use of its products and services with surveillance, computer vision, or cloud storage capabilities contributes to human rights violations For (against management recommendation)   A vote in favour is applied as LGIM supports such risk assessments as we consider human rights issues to be a material risk to companies
7 REQUESTING AN ALTERNATIVE DIRECTOR CANDIDATE POLICY - adopt a policy of promoting significant representation of employee perspectives among corporate decision makers by requiring that the initial list of candidates from which new board nominees are chosen (the “Initial List”) by the Nominating and Governance Committee include (but need not be limited to) hourly employees. The policy should provide that any third-party consultant asked to furnish an Initial List will be requested to include such candidates For (against management recommendation)   A vote in favour is warranted, as the company faces significant controversies related to treatment of its employees.
9 REQUESTING A REPORT ON WORKER HEALTH AND SAFETY DIFFERENCES - examining whether Amazon’s health and safety practices give rise to any racial and gender disparities in workplace injury rates among its warehouse workers and the impact of any such disparities on the long-term earnings and career advancement potential of female and minority warehouse workers. Among other things, the report shall include lost time injury rates for all warehouse workers, broken down by race, gender and ethnicity For (against management recommendation)   A vote in favour is applied as despite the company committing to undertake a racial equity audit, we do not know the timeline for this report, therefore we are supporting to ensure that the company commits to providing shareholders with additional information on this important issue.
10 REQUESTING ADDITIONAL REPORTING ON RISKS ASSOCIATED WITH THE USE OF CERTAIN CONTRACT CLAUSES - public report assessing the potential risks to the company associated with its use of concealment clauses in the context of harassment, discrimination and other unlawful acts For (against management recommendation)   A vote in favour is warranted because although the company has produced a report that provides disclosure on the company’s use of confidentiality clauses and its consideration of potential risks, concerns remain regarding how the company handles these clauses in practice.
12 REQUESTING ALTERNATIVE TAX REPORTING - issue a tax transparency report to shareholders, at reasonable expense and excluding confidential information, prepared in consideration of the indicators and guidelines set forth in the Global Reporting Initiative’s (GRI) Tax Standard For (against management recommendation)   A vote in favour is applied as we support tax disclosure in line with the GRI standard as it provides full transparency country by country.
13 REQUESTING ADDITIONAL REPORTING ON FREEDOM OFASSOCIATION - a report analyzing how Amazon’s current human rights policies and practices protect the rightful application of the fundamental rights of freedom of association and collective bargaining as guaranteed by the ILO Declaration on Fundamental Principles and Rights at Work and the UN Universal Declaration of Human Rights. For (against management recommendation)   A vote in favour is applied as LGIM supports proposals that are set to improve human rights standards or policies as we consider this issue to be a material risk to companies and we want to ensure that human rights policies cited are being adhered to.
15 REQUESTING A POLICY REQUIRING MORE DIRECTOR CANDIDATES THAN BOARD SEATS - The board needs democratic reform to elect members from more diversified candidates. Shareholders should have the right to choose from more candidates than the number of the board of directors to be elected. Against (in line with management recommendation)   A vote AGAINST this proposal is warranted, as the proponent has not made a compelling case that the proposed change in the director election process would improve the composition of the board or the performance of the company.
16 REQUESTING A REPORT ON WAREHOUSE WORKING CONDITIONS - independent audit and report of the working conditions and treatment that Amazon warehouse workers face, including the impact of its policies, management, performance metrics, and targets For (against management recommendation)   A vote FOR this proposal is warranted. Shareholders would benefit from increased disclosure through third-party auditing on warehouse working conditions.
17 REQUESTING ADDITIONAL REPORTING ON GENDER/RACIAL PAY - Black workers’ hourly median earnings represent 64% of white wages. The median income for women working full time is 83% that of men. Intersecting race, Black women earn 63 cents, Native women 60 cents, and Latina women 55 cents. At the current rate, women will not reach pay equity until 2059, Black women until 2130, and Latina women until 2224. For (against management recommendation)   A vote in favour is applied as LGIM expects companies to disclose meaningful information on its gender pay gap and the initiatives it is applying to close any stated gap as this additional information will better help shareholders measure the progress of the company’s diversity and inclusion commitments.

So what’s happened? Late last Thursday the Italian government published its long-awaited economic and financial document, in which it set out plans to run a deficit of 2.4% in each of the following three years (i.e. 2019-2021). This is at the upper end of recent market expectations, and abandons the previous government’s aims of balancing the budget by 2020 (a medium-term objective enshrined in the Italian constitution).

 

 “The government’s fiscal plans are at the upper end of recent market expectations”

 

This proposed fiscal easing is concerning for investors, not least given the already high debt levels of the country this far into a global economic expansion. We believe the next global recession is likely to expose the euro area’s debt vulnerabilities, and Italy is at the top of pile (the debt pile, that is!) – the potential meltdown could be worse than anything my last gelato experienced. As a result, the yield on 10-year Italian government bonds (known as BTPs) has jumped sharply from under 3% to around 3.4% at the time of writing, taking the BTP spread over German bunds (seen as the euro area’s risk-free rate) to near 3% (see chart).

 

“The potential meltdown will be worse than anything my last gelato experienced"

 

This, in turn, makes the country’s debt burden more difficult to service, potentially creating a vicious downward spiral resulting in a debt crisis.

 

Although BTPs have sold off, and there has also been some weakness in the euro, we believe that the situation is unlikely to trigger a full-blown Greek-style crisis just yet – a Portugal-style playbook is more likely (i.e. some capitulation from the government). Italy is still running a sizeable primary surplus (i.e. not including debt interest payments), which should be enough to keep debt trending slightly lower, while domestic holdings of BTPs are still relatively high. And although Moody's may resolve its outstanding credit ratings watch for Italy with a downgrade – which is one of the market’s key concerns – it shouldn’t be forgotten that one notch lower to Baa3 would still be an investment grade rating. It is the prospect of being rated sub-investment grade that would be more concerning, and remains a tail risk.

 

However, while the government’s fiscal plan keeps annual borrowing below the EU’s 3% deficit restriction, the European Commission also requires a structural adjustment of 0.6% (given Italy’s high stock of debt) and such is likely to request some corrective measures when it passes judgement on the 2019 budget in November.

 

 

“We believe that the situation is unlikely to trigger a full-blown Greek-style crisis”

 

 

In addition to the fiscal and economic gyrations, investors will be keeping an eye on the political tensions, particularly with the Lega continuing to lead the opinion polls. As I pointed to on CNBC, markets have also been sensitive to the fate of the finance minister, Giovanni Tria, who has tried to keep the deficit in check and played a hand in placating investors over the past couple of months.

 

In terms of the Asset Allocation funds, while we don’t currently hold a position in BTPs, the market reaction to the Italian situation over the past week has helped our short euro stance. It also serves as a timely reminder that political risk in Europe is still a live concern and that the EU has a number of challenges to deal with – not just Brexit – in the coming months. 

 

Update: the government has now submitted the draft budget to the European Commission…hear my latest thoughts on Sky News.

Hetal Mehta

Senior European Economist

Hetal is an economist with a focus on the UK and Europe. She has worked for HM Treasury, Oxford Economics and Daiwa Capital Markets, but her real claim to fame is sharing a stage with Sir Ian McKellen. This love for drama is just as well given the excitement of keeping tabs on [insert latest European country]-xit. Away from work, you'll either find Hetal concocting culinary masterpieces (!) or punching the lights out at a HIIT class.

Hetal Mehta