Sunday, November 7, 2010

Italy: Recovery still on track

Italy: Recovery still on track

  • Italy’s GDP grew by 0.5% qoq in 2Q, driven by robust export growth, while domestic demand was weak, with the only exception being soaring machinery investment.
  • The strong industrial production reading in August, mainly due to resilient external demand, was a positive surprise versus our expectations of moderation in industrial activity already in 3Q.
  • However, we don’t expect the industrial recovery to continue at the same solid pace going forward. Activity in the services sector is likely to cool down as well.
  • Overall, our forecast of 0.3% quarterly GDP growth in 3Q remains on track, but we acknowledge that risks are skewed to the upside.

Strong 2Q, moderation ahead
In 2Q10, Italy’s GDP grew by 0.5% qoq, mainly supported by a robust expansion of exports (3.3% qoq), while domestic demand remained weak (0.3% qoq), with the notable exception of a strong increase in machinery investment, which reflects the support coming from the government incentive and also the resilience of foreign demand. In contrast, investment in construction kept contracting and private consumption stagnated.

Macroeconomic data published in the last month provide further positive signals on the growth picture in 3Q. For this quarter, we expect ongoing support to GDP growth from net exports, although at a more moderate pace than in the previous quarter when the contribution was +0.6pp to quarterly GDP.

Moreover, we believe that a potential drag on GDP should stem from a correction in machinery investment, due to the negative impact of the expiry of the government incentive known as “Tremonti-ter”, while private consumption should continue to tread water.

Against this scenario, we acknowledge that the latest data on industrial activity don’t provide a clear-cut picture for investment dynamics in 3Q. August industrial production came in stronger than expected, rising by 1.6% mom, after an upwardly revised 0.3% increase in July; this was the largest monthly increase since January 2010. Production of capital and intermediate goods was up strongly, increasing by 4.8% and 3.1% mom, respectively, while consumer goods output rose 0.5% mom, driven mainly by a solid performance in durable goods (1.9% mom). This large industrial production increase is a positive surprise versus our expectation of moderation in industrial activity already in 3Q, and seems to suggest that the good resilience of external demand remains the main support factor for domestic production. The strong increase in industrial new orders in August, up by 7.3% mom thanks to a surge of foreign orders, provides further evidence of this view.

However, we believe that it is quite unlikely that the industrial recovery will continue at the same solid pace seen in August. We note that: 1. industrial production figures can be particularly volatile in August when many production plants are closed, and a moderating trend in activity started to become visible already in July; 2. Business confidence peaked at around mid-year and surveys now hint at a moderate loss of momentum in manufacturing activity. In September, the PMI declined for the second consecutive month to 52.6, before rising again in October (to 53 vs. the cyclical high of 54.4 in July), while the ISAE business confidence is currently still hovering around its cyclical peak; 3. We expect the production of capital goods to soon enter a weakening trend, due to the end of the government incentive for machinery investment in June.

The fact that sentiment among capital goods producers is off a peak seems to be consistent with our expectation; 4. Finally, the less volatile 3M/3M growth rate of total orders and foreign orders in August showed a 2.1% and 4.5% performance, respectively, which is a much less strong showing than in 2Q. Hence, if we are correct, August industrial production data should be fully corrected in September (we expect a monthly drop in the 1.5% area), leaving the qoq industrial production increase in 3Q at around 1.5%, vs. 2.2% in 2Q and 1.9% in 1Q.

Moreover, developments in service industries add to the evidence of a recovery that is starting to lose steam. In September, the services PMI showed no signs of re-gaining any momentum, with the index moving sideways to 51.3 from 51.4 in August. Although this indicator has been volatile at the beginning of quarter, bouncing above and below the 50 threshold, a declining trend with respect to 2Q is clearly visible.
Coming to the household sector, we have some indications that the worst for private consumption is probably behind us. Although it’s too early to anticipate a sustainable recovery trend, August-September car sales marked a moderate improvement (see above chart) after the 22.2% qoq drop posted in 2Q.

Thus, it seems that the drag on consumption coming from the expiration of the incentive scheme in the automotive sector could be close to an end. In the same direction, the retail PMI – which tracks consumer spending dynamics fairly well – increased by around 4 points in 3Q, from 42.1 to 46.5. Overall, when we plug all this new information into our consumption model, we end up with a still modest 0.1% qoq gain in 3Q (in line with our original assessment), after the stagnation seen in 2Q.

Thus, what does all this mean for GDP growth in 3Q? Assuming a correction in industrial activity in September that leads to a quarterly IP increase of about 1.5%, and taking into account the bottoming out of car registrations and the stabilization at around 51 in the services PMI in 3Q (from 53.2 in 2Q), our GDP model delivers a 0.3%-0.4% qoq increase. This estimate is clearly subject to some uncertainty and risks but it tells us that our current forecast for a 0.3% GDP increase in 3Q doesn’t look overly pessimistic, at least for now.

Accordingly, we decide to stick to our call, although we acknowledge that risks are tilted to the upside. Just for comparison, if industrial production were to fall by only 0.7% mom in September (as envisaged, for example, by Confindustria) with no revisions to previous data, industrial output would still mark a 1.9% qoq increase in 3Q, consistent with GDP expansion of 0.4%-0.5%. This should imply that the expected growth moderation could be delayed, leading to an upward revision to our 2010 GDP growth forecast to at least 1.2%, from the current 1.0%.
Full report: Italy: Recovery still on track

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