Assessing the effect of Brexit while riding the emotional wave and the initial reactions of the markets risks leading to hasty conclusions, especially when faced with the explosion in volatility and extremes in judgment, almost always irrationally based.
An interesting (and in certain ways, amusing) comment from the past comes to mind, made by the English economist Benjamin Graham who, in 1949, wrote “The Intelligent Investor”. The book was considered a landmark reference for investment and the value investing approach, and Warren Buffett has called it the best book about investment ever written.
The phrase is: “In the short run, market is a voting machine and sometimes people vote very unintelligently. In the long run, market is a weighing machine and the weight of business and how it does is what affects values over time.” Without commenting further, it seems particularly apt to the current situation.
Let’s take a look at the 6-month outlook from the standpoint of business and the daily operations of companies, before returning to the current situation and the potential impact of Brexit.
From a business standpoint, more reassuring signs can be seen in the The European House – Ambrosetti Club sentiment index which foresees economic changes that are underway, trends for the future and their impact on society and corporate investment. While it is true that these findings in part pre-date Brexit, findings following the referendum do not show any drastic changes in a negative sense. The greatest threats are linked to the disintegration of the political blueprint and stability of the European Union and the Eurozone. It goes without saying that disintegration of the European project would result in inevitable, and devastating, economic and social impacts.
The Ambrosetti Club indicators are developed on the basis of a survey carried out with over 350 businessmen, CEOs and top management of leading Italian and multinational companies operating in Italy.
Thanks to daily contact and specially-developed surveys, we obtain a 360° perspective on information about the outlook our business community has on economic trends, planned investment, on sales trends, new orders and the evolution in the markets for its goods and services.
The indicators should be read as follows: values above zero indicate that sentiment is positive with the forecast of an expansion in economic activity, whereas values below zero indicate that sentiment is negative and with the forecast of a contraction in economic activity.
The indicator regarding current sentiment about the Italian economy is 24.7 points, nearly identical to the 24.6 points registered in March. Despite the numerous areas of uncertainty in the second quarter of the year which led some institutions to lower their forecasts for growth, prevailing sentiment is that the economy has not worsened compared to the first quarter. The fundamental aspects remain positive, with growth rates low, but on the plus side.
Forecasts for the end of 2016 also indicate a slight improvement compared with the current situation. The economic outlook indicator is slightly positive at +3.4, an inversion of the negative sign of the first quarter. The indicator of expectations has also taken a plus turn and, although limited, is an encouraging sign given that the evaluation is carried out starting from the current state of the economy which, if not not dazzling, is not recessionary.
In terms of employment, the indicator has taken a more forceful positive turn with the third-best result since the beginning of our surveys, with a value of 8.9 points and registering the sixth consecutive result on the plus side.
Erwin Rauhe, Vice President of Basf Italia and member of the The European House – Ambrosettimbrosetti Club, has begun to have a tangible sense of the positive effects of the Jobs Act in reducing labor costs which represent one of the main correction valves against market trends compared with the impact on total costs.
Regarding this, Eurostat has confirmed that labor costs in Italy dropped by 0.8% in 2015, the only country for which this was true in the Eurozone and European Union where they increased, respectively, by 1.3% and 1.9%. The level of available jobs also decreased in Italy, compared with an increase on a European level.
The improvement in job market conditions seems to have continued even following the reduction in tax breaks for new employees decided by the government. In coming months we will see if these favorable trends become structural.
There are also positive signals on the investment front. The indicator is at 23.3, at the higher levels registered in 2015 and up sharply from the 15.6 figure seen in March.
In brief, the results of the Ambrosetti Club Economic Indicator confirm a basically positive situation in the economy, employment and investments. These results followed on earlier findings that already indicated positive signs that we were “sailing with the wind at our backs”.
Erwin Rauhe notes that people have become used to working in the midst of an uncertain macroeconomic and geopolitical context. The market, he says, is “doing well structurally” and BASF continues to invest in Italy as shown in its most recent acquisitions, including a company employing 80 people.
The deflationary push has lessened and by the end of the year manufacturing prices should show some slight growth, both because of trends in oil prices, but also because of a saturation in productive capacity.
Javier Hernández Sinde, CEO at Gas Natural Italia and member of the The European House – Ambrosettimbrosetti Club, does not foresee any particular effects of Brexit on business in Italy. The main uncertainty about the future is connected to regulatory change which will occur over the next year in that part of the market where tariffs are regulated and set by the Italian Regulatory Authority for Electricity, Gas and Water . The setting of tariffs will determine the profitability of investments and this will have an impact on the potential for further investments in the sector. On these questions, the Italian Regulatory Authority for Electricity, Gas and Water is engaged in a constructive dialog with sector operators and sets fixed time schedules. Naturally, the earlier the rules are known, the earlier investments can be made. In addition, for this sector, the overall trend in terms of sales is connected to domestic consumption which is not expected to decrease this year.
Given this picture, we think that Brexit does not represent only a negative external shock with risks for our economy, but could also provide an opportunity for Italy from an economic standpoint.
In the short-term, this shock could produce significant real fallout for the economy that would slow economic growth in Europe and Italy which, more than other countries, is weak because of the level of its public debt. However, the results of our analysis and the sentiment of the Italian business community would seem to mitigate against the danget of a recession.
There are a number of reasons that would support this view.
Ten-year interest rates on debt have remained basically stable. Two days after Brexit, Italy’s 10-year bond yield was 1.44%, and a week later settled at 1.22%, an all-time low. The Italy-Germany bond spread, which had risen slightly to 160 at the time of Brexit, quickly returned to around 140. This burst had more to do with the drop in bund earnings than lack of confidence in Italian debt. The 10-year bund yield, considered to be a safe investment, dropped to -0.2% and, given the fact the spread is the difference between the two 10-year interest rates, the drop in the German rate on its own resulted in an increase in the spread. In short, also thanks to the extraordinary efforts of Mario Draghi at the ECB, Brexit did not rekindle worries about sovereign debt. Italy continues to finance itself at extremely low and negative interest rates up to 5 years (in these cases, it should be remembered, the market pays Italy to loan it money; in other words, in five years, Italy will repay less than it receives from the market in loans).
We believe the concern about the Italian banking system is excessive, a system which is also undergoing a full transformation. The entire European banking system is suffering, and this can be seen in the stock market performance of the main foreign banks which, since the beginning of the year, have registered trends of between -30% and -50%. The sensation that Italy is suffering more than others is due to the greater weight of the financial sector on the Italian stock exchange compared with others.
Our trade vulnerability with the United Kingdom is important, but much less so than with Germany and France and countries in northern Europe, such as the Netherlands and Belgium. Italian exports to the United Kingdom are about 27 billion dollars, one-fourth of Germany’s which exports nearly 100 billion dollars to the UK. The trade surplus gap is even greater: Italy generates a 12 billion dollar trade surplus with the UK, compared with Germany’s 50 billion dollars.
This also explains the more prudent behavior of the German government which, contrary to the line adopted last year with Greece, has immediately shown a more friendly and patient attitude. France (40 billion dollars), the Netherlands (55 billion dollars) and Belgium (34 billion dollars) also export more to the UK than Italy.
And the last point is that, over the last five years, Italy, through its actions, has regained reliability and credibility in Europe and internationally. Italy’s role has emerged, not just in the face of political collapse, but also as a result of French weakness and the political impasse in Spain which, despite two elections in six months, seems to be having problems once again in forming a government.
Given this renewed international credibility, we believe there must be a concerted effort to relaunch the role of Italy as one of the leading countries on the European continent. Policy initiatives must be activated immediately to put forward Italy and the city of Milan as the headquarters of two European authorities currently based in London that must be transferred: the European Banking Authority (EBA) and the European Medicines Agency (EMA), which is also headed superbly by an Italian, Guido Rasi.
In terms of the EBA, competition exists from Frankfurt and Paris which are the homes, respectively, of the ECB and ESMA (European Securities and Markets Authority). If we consider the EMA, Lombardy already has one of the most important health and pharmaceuticals supply chains in Europe, with specialization in medical applications and biotechnology research.
Through the creation of initiatives to attract and create incentive, Italy must also put itself in a position to draw all the Chinese companies which, until recently, utilized the United Kingdom as their port-of-entry to Europe or, rather, as their entry-point into the European market.
All the potential exists to think and act as a major power, in the knowledge that, now, the answer is not just economic, but must also be political.
Managing Partner and Chief Executive Officer,
The European House - Ambrosetti