The Outlook For the Italian Economy Entering 2008

by Edward Hugh: Barcelona

Evidence of a growing slowdown in the Eurozone economies continues to show up across the board. German retail sales, for example, fell for the third consecutive month in December according to the Bloomberg purchasing managers retail sales index released at the end of December. The index came in at a seasonally adjusted value of 44, compared with 43.6 in November. A reading below 50 indicates contraction. Retail sales across the entire 13 nations euro bloc also declined in December. In Spain the evidence for a sharp slowdown is quite general now, and only in France does the economy continue to show some level of resistance to the downward march.

Euro zone purchasing managers surveys for the manufacturing sector also tend to confirm the idea that the economy of most member states has slowed in the fourth quarter despite what seem to be pockets of resistance in some countries. The purchasing managers index for the euro zone manufacturing sector eased to a final 52.6 in December from 52.8 in November. The manufacturing PMI for the whole zone has managed to remain above the October low of 51.5, but the December reading is still the second weakest figure since Aug 2005.The German PMI eased slightly but held up better than expected, slipping to 53.6 from 53.7 against market expectations for a decline to 53.2.

While in Italy Things Continue To Go From Bad to Worse

Italian retail sales declined for a 10th successive month in December as a bleaker economic outlook damped consumer demand during what should have been the busiest shopping period of the year. The seasonally adjusted purchasing managers index of retail sales dropped to 44.7 from 45.3 in November. The reading has now been below 50, the level that signals a contraction in sales, since February. Even record low unemployment of 7.2 percent has failed to spur purchases, prompting retailers to expect lower sales next month.





The Italian manufacturing PMI also fell more than expected, declining to 50.7 from 51.3 (a level at which industry is just expanding, but only just), compared with expectations for a decline to 51.0. This meant the index was at its lowest level for more than two years.



Italian consumer confidence continues to trawl the bottom, falling to a four-month low in December as signs that economic growth is slowing prompted households to cut back on spending. The Rome-based Isae Institute's index, based on a survey of 2,000 families, fell to 107 from 107.6 last month.

And Italian business confidence declined to a two-year low in December after a strike by lorry driver disrupted production and as manufacturers brace themselves for the likelihood of slower growth. The Isae Institute's business confidence index fell to 91.8 from a revised 92.1 in November, the Rome-based research center reported today. That is the lowest since December 2005, when the index reached 91.5.



The pace of increase in Italian household spending - long a soft point in Italy's less than stellar performance even though it accounts for nearly two-thirds of Italy's economy - continues to decelerate, only growing by 0.2 percent in the third quarter when compared with the second, down from the 0.5 percent rise achieved in the second quarter, and the 0.7% q-o-q rate achieved in the first quarter.




Household spending won't be helped any by Italy's inflation rate, which jumped in December to the highest level in more than four years as record oil prices pushed up the cost of petrol and transportation. Consumer prices gained 2.8 percent from a year earlier, as calculated by European Union methods, the Rome-based national statistics office said. That's highest rate of increase since November 2003.



Italian GDP growth seems to have peaked back in the 70s (or maybe earlier, since I don't have data for the pre 1970 period), and indeed since 1990 Italian GDP growth has only managed an average of something like 1.4% growth per annum. As can be seen from the chart the rate of growth has been, if anything, even lower since 2001, and there is no good reason to believe that this underlying tendency has been reversed, indeed there are strobg theoretical reasons for anticipating quite the contrary, as Italy ages.

2008 Forecasts: The OECD in December revised their 2007 Italian forecast down to 1.8%, and the 2008 one down to 1.3%. Confindustria also revised their forecast down in December, arguing that growth would slow to 1 percent in 2008 from an 1.8 percent this year, citing factors like the rising cost of food and oil and the rise of the euro against the dollar. Such numbers are clearly not encouraging, but arguably downside risk for 2008 is greater even than either the OECD or the Confindustria forecasts reflect Morgan Stanley's Vladimir Pillona is somewhat more sanguine. While presenting the MS central forceast for Italian economic growth to slow to 1.0%Y in 2008, from 1.8%Y in 2007, he goes on to note that "even annual GDP growth of 0.5%Y next year has a significant possibility of occurring, as shown by our model’s forecast error bands".

I personally will be very surprised if we still see calendar year 2007 anyhting like as high as 1.8%, but more to the point even 1.3% may be rather on the high side if we get a significant deterioration in the external environment, especially in Eastern Europe on which Italy is fairly dependent, and where the Italian banking sector has significant exposure. So that puts me much nearer to Pillona's "basement bargain" number of 0.5% than to any of the others. One of the reasons for my pessimism relates to my assessment of Italy's current trend growth rate, and to the level of fiscal and monetary tightening which may be operating on the economy even as it slows. During 2007 the Italian govenment has been running a fiscal deficit of comfortably below the 3% of GDP required by the EU commission. But since this fortunate situation was in part acheieved by the use of one off measures, and in part by the strong tax inflow from the above trend growth, the government will need to maintain a comparatively tight fiscal stance to keep things on course, and any attempt to further loosen may run into real problems with the EU commission and the credit rating agencies. And as I keep arguing, it is very hard to see an accomodative monetary posture from the ECB in the near future. The IMF in their October World Economic Outlook came in with a similar figure of 1.3% for 2008, the Economist Intelligence Unit is forecasting 1.7% in 2007 and 1.4 in 2008, and the latter 2008 figure was also endorsed by the EU commission in its November forecast.

As I indicate, my own view is well to the downside of all this. The only apparent bright spot on the horizon is employment, but I am dubious that in the context of Italy's ageing workforce this will work through as some are hoping, as I expain at some considerable length in this post here. My opinion is that Italy will enter recession at some point during 2008, and that we may well have 2 consecutive quarters of negative growth. The continuing high euro will maintain pressure on Italian exports, and high oil and food prices will maintain pressure on the inflation front, at least in the firts half of 2008. At the same time, and despite rumours that Romano Prodi's government is compemplating a large tax cutting package, I anticipate that the fiscal environment will remain tight. Italy's large (106% GDP) accumulated debt, and the vigilance from the gentlmen at Standard and Poor's and the other credit rating agencies more or less guarantee that.

As most of the forecasts suggest, we have been seeing growth which is somewhat above trend during the upswing in the last couple of years, so it would not be surprising if we now saw some below trend growth. Trend growth (over a 5 year average) in Italy may even have fallen into the 0.5 to 1% range, so if I have to put a number I would say 0.7% with a definite "downside risk" tag attached. The nearest forecast to this that I have seen is the 1% one from the Morgan Stanley GEF team. The implications of such sustained low growth are, I think, important, since if Italy cannot find the way to raise trend growth up towards the 2% mark there is simply no way the government debt can be stabilised and sustained. And with each passing year we have one year less to crunch time.

Japan in 2007 and Looking Forward to 2008

By Claus Vistesen Copenhagen

It is the 1st of January and people are probably still recovering from a night of bubbles, bombs and broken records in alcohol intake. However and although I guess that most of our readers are enjoying a day away from the computer stocking up with plenty of fast food, coffee and pain killers we are going to break radio silence here at GEM and have a look at Japan in 2007 and forward into 2008. Over at the Japan Economy Watch a whole slew of notes are already up which substantiate and elaborate on the points below so if you are into details on all of this JEW is the place to go. What follows is a note from my personal blog Alpha.Sources but it ties in excellently with the general coverage of Japan and the global economy here at GEM

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The general coverage of Japan here at Alpha.Sources in 2007 has mainly been centered on two issues; BOJ watching and tracking a series of monthly data on prices and domestic consumption. This line of analysis has then entered the much wider and encompassing general analysis as it has been presented over at the Japan Economy Watch blog. As for the series of monthly data tracking I don't have the entire 2007 represented with specific analyses but most of it as can be seen from the list below.

Japan, Still Stuck (April 28th)

Playing the Waiting Game in Japan (June 29th)

Is Japan Heading for a Recession? (September 3rd)

Finally Some Good News from Japan? (September 28th)

Where is Japan Heading? (November 4th)

In the new year, I would like to present the fruits, as it were, of my labours on these notes as I have tried to knit together a methodology which can track the evolution of domestic household demand in Japan. Of course, this is nothing more than a mixture of data from various sources but the overall and underlying argument is pretty important. Quite simply, I am hypothesising that domestic demand won't be a future driver of Japanese growth as many has proclaimed and in order to do that I obviously need to tie my argument to some tangible data which is basically what this whole 'consumption expenditure watching' exercise has been all about. Let me consequently round up 2007 such as it is with Japan moving closer to what increasingly looks like a recession. As per usual Edward has already beaten me to it over at JEW with a note covering the majority of the recent data releases.

For now, let me present my traditional graph of the evolution of the three key price indices in Japan which shows us one of the big stories coming out of Japan in here in the twilight of 2007, the return of inflation.

As can readily be seen, inflation in the two main core indices took a leap towards the sky in October and November and I would expect the same in December. Immediately we should note that the stripped core index which excludes fresh food and energy is still in negative territory but is closing in on the 0% mark. However, the distinction between these three inflation measurements is not without importance since they tell a cautionary tale of the current inflation dynamics in Japan. You see, and as Stefan Karlsson ponders accordingly, it has widely been recognized that the day Japan returned to inflation would be the day we could finally call an end to a decade long slump in the Japanese economy. As I have argued before this essentially represents a fallacy. At the current juncture it is of course almost painfully obvious and almost a bit tragicomic really not least because history it seems has been well and truly forgotten or as Edward puts it ...

Basically the problem facing Japan is that the up-tick in inflation is taking place at precisely the same moment as there is a downtick in several other key economic indiactors. What this means basically is that Japan is getting squeezed on both fronts. (...) The last time inflation showed signs of life in this way, Japan was pushed straight off into recession. History may well be about to repeat itself yet one more time here. But the real question is when will people actually start to learn some of the costly lessons experience is offering us?

In other words, what we are seeing are not demand-pull inflation which would have been the hallmark sign of a recovery driven by domestic demand but rather cost-push inflation which is being imported through high energy and base commodity prices; remember all that flurry of the rising price on mayonnaise, Starbucks lattés as well as recently wholesale prices which would rear their head in the PPI indice(s). On the general situation and as per usual, Morgan Stanley's Takehiro Sato also remains calmly on top of the situation in his recent note Inflation Irony where the bottom line is the following and I cannot but agree.

Indeed, it is ironic if the BoJ has to consider the monetary accommodation in the midst of the long-awaited recovery of the CPI rate.

So, as always in Japan the headline message which in this case tells us about a return to inflation is masked by a considerable underlying story and one which is not merely about a technical discussion of different kinds of inflation. Much more pertinent however it raises a fundamental question as the kind of price dynamics we can expect in a country with Japan's demographic profile. To that end the recent Christmas bumper edition Bizcast on Japan hosted by, among others, Ken Worsley for the Japan Economy and News blog has an interesting discussion. Lastly, we should return to the graph fielded above and note that Japan is still formally in deflation measured by internal price dynamics proxied by the general index stripped of fresh food and energy. Of course, this measure might soon enough shoot in to positive territory as well if the current trends continue but if and when it does it won't signify the coming of a sustainable recovery in Japan.

Moving onwards to the second part of my analysis as I have been presenting it throughout 2007 we have three graphs of domestic consumption.

As I noted above, I am still pondering the general methodology here but the graphs above still manage to convey some important general messages. The first graph plots y-o-y changes in consumption expenditures and above all it is important because this is the measure which is traditionally reported by the business press. As such, I have been attaching a forecast to this series throughout my analysis as I predicted that the rolling y-o-y average would not exceed 1%. The actual numerical forecast is not that important here but more so is the overall message in the sense that whatever underlying trend we expect of domestic consumption it will not be enough to pull forward the Japanese economy towards the much hailed sustainable recovery as well as it won't be enough to decisively pull Japan out of deflation. Currently as of November the rolling average stands at an increase of .75% and knowing that December might still succeed to shatter my forecast I am smug enough to call this one in the box. The two other graphs are important because they can be used to differentiate the traditional headline measure. As for the month-on-month series it clearly shows what we know now, namely that the trend measured by intra-year dynamics clearly is one of a down trending path. As for the real index (100=2005) it is there to give the big picture and to show the current trend relative to a fixed historic benchmark. At this point in time the graph really does not add anything as it seems to have been pretty much shadowing the other series. However, what will be interesting in the new year and especially if Japan falls into sub-zero growth rates will be to see the relative slump in domestic consumption and more importantly the relative 'recovery' which may come in the future. My guess is that the ups and downs will be there but that the spikes and troughs will be situated lower and lower on the index as we move forward.

Conclusively, the trend in domestic demand in Japan is very clear. Compared to 2006 which was clearly a pretty abysmal year with respect to monthly consumption expenditures 2007 will see an overall increase in monthly consumption expenditures. However, and in the light of the analysis above it is clear that although the trend is positive it is not near enough to confirm the claims of how Japan is heading for a sustainable recovery driven by internal demand. For a detailed look at the recent monthly GDP figures for October (the last one out) published by the Japan Center of Economic Research is worthwhile and confirms the rather gloomy outlook.

Finally in this note I am going to field a series of predictions for Japan in 2008 or perhaps as Macro Man put it recently we should rather be talking about 'non-predictions' ... In any case and now that I am talking about him why don't we have a look at those of MM's predictions where Japan is involved, just to get us started that is ...

• My first prediction moves in alongside Macro Man's fifth prediction in noting that the BOJ will not raise rates in 2008. This may not seem to be a particularly outlandish call but remember that all through the first half of 2007 expectations had it that the BOJ would end the year at 1% or thereabouts. This was clearly a long-shot and here on the brink on 2008 it paves the way for another one across the bov, namely that 2008 will see the return to ZIRP. Yep, now I have said and I will as always be ready to eat my words just as I will have to eat them for not calling it right when I said that 2007 would end on a ZIRPy note. So, before you pull the plug on your Alpha.Sources RSS feed here are two reasons as to why Japan might yet again return to ZIRP in 2008. Firstly, I believe that the current slowdown will be tougher than most people anticipate and secondly; there is the political situation. You see, the BOJ is set for a change of leadership in the Spring and with Fukui leaving the seat without being able to normalise rates in any given sense of the word the future course of the BOJ seems to be situated in somewhat of a limbo in terms of strategy. This needs to be tied together with the general political situation in Japan. This is of course a pretty messy topic but it essentially shores up at the point about how the new leadership at the BOJ needs to be ratified by both houses of the Japanese parliament and how the Democratic Party of Japan (DPJ) might use their majority in the upper house to stall the installation of a new BOJ leadership. This will mean that political interests proxied by the Ministry of Finance (MOF) will be brought temporarily closer to the decision making on monetary policy if this happens in the midst of a tougher than expected slowdown it might just be what pushes the needle in favor of ZIRP. Conclusively, I see the return to ZIRP as a plausible outcome mainly on the basis of a larger than expected deterioation of economic fundamentals with the likely political situation as a potential trigger.

• Takehiro Sato recently told us to Buckle Up and sit tight as we were moving for what he called a 'mild recession.' All this very quickly turns into a battle royal of definitions since what exactly is a recession not to speak of a mild one? Well, according to Sato a mild recession would be a series of quarters (minimum two in a row) with sub 1% growth in output. I really wouldn't want to rob Roubini of his alter ego Dr. Doom but when I look at Japan from all angles available I see a recession coming which would be defined as at least two consecutive quarters of below 0% growth. I concede that this is a very uncertain call and in essence we would perhaps be better off by just calling it a tough slowdown and forget neatly about the numbers. However, we don't quite have that luxury I feel since if Japan really falls into a recession it is going to bring out all kinds of ghosts from the past. As I noted above I think ZIRP will be one of them but also the ever looming government debt will race to the forefront of the agenda I think especially if some of those rating agencies find it in them to actually lower the sovereign debt rating of Japan. The concrete ammunition for the recession call is pretty clear I think. The housing start debacle which saw a sharp reduction in housing starts and thus residential investment is likely to cast considerable shadow into 2008 as well. Domestic consumption is not likely to provide any kind of shield especially not with a decline in real income and a near decade low reading on the consumer confidence indices. The real key as always in Japan will the evolution of external demand and as a derivative of this corporate capex and industrial production. On the latter front November saw a decrease of 1.6 % but the overall trend in IP is still very much positive. External demand is likely to recede overall due to a global slowdown but remember that this is more about re-coupling than de-coupling and even if the US will stop buying those Toyotas as fiercely as in 2007 other markets may help offset this. All I can say is that it remains to be seen.

• Another big story for 2008 is the potential for the Yen to rise to such uncomfortable levels against the USD that Japanese authorities will find it necessary to intervene. Well, perhaps I should reiterate slightly here in the sense that this was suppose to be one of the big stories. As such and back in early November where the trouncing of the Dollar was at almost epic proportions (hell, the Danish kronor even saw 4.98 USD for a minute there) market participants were positioning themselves for a potential intervention on the Yen as the USD/YEN drifted ever so closely to the 100 mark. I asked the question the 9th of November. Of course, and as Edward succinctly puts it his most recent post this has turned into something of a mute point. Consequently, the USD/YEN has moved into much more comfortable territories from the point of view of Japan at least trading at around 114-115. In terms of actual calls this is approximately where I saw the USD/YEN for the end of 2007 (a bit too low actually, I was looking for more like 118-120) and clearly a USD/YEN at levels consistently below 110 and perhaps even 105 are not likely to go down well at all with Japanese authorities for an extended period. I will refrain from a y-o-y call on the USD/YEN since such calls are absolutely pointless (although I do respect Stephen Jen's ongoing stalwart efforts of satisfying Morgan Stanley's clients), especially in these day and age where technical analysis much more than fundamentals analysis seem to be in vogue amongst currency traders . Rather I am moving in behind Macro Man in proclaiming that we won't see any intervention on the USD/YEN in 2008. In short, I would like to have the real option to adjust as I move along. I do want to emphasise though that Yen weakness and carry trade are set to be topics well up the 2008 agenda, at least from where I am sitting.

So, these are the predictions and analysis on Japan such as it is for 2008 (for the record, here are my 2007 predictions and analysis). As always I encourage people to let me eat my words with gravy and extras if it turns out that I am wrong. In the new year I will continue to move forward with my general domestic demand and inflation analysis, BOJ watching as well as general observations on the great land of the rising sun. What is left is then to wish you all a happy new year and a prosperous one too.