Four events stand out in the first week of October: the situation in Italy, UK Prime Minister May’s speech at the Tory Party Conference, the EMU PMI, and the US jobs data.  

We suspect that the market overreacted to the Italian government’s 2.4% deficit projection. It is not an unreasonable outcome given the election. Italy may still very well run a primary budget surplus in 2019, and outside of Moody’s, the other rating agencies may grant Italy some time. The EC itself may not be as confrontational if there is a lesson to be learned from the experience with Greece.

May’s Chequers plan is not acceptable to the EC without a backstop for the Irish border, which the UK rejects. Nor is it acceptable to her party critics who may still launch a leadership challenge. A confirmation of the eurozone’s flash PMI will leave it with the lowest quarterly average since Q1 17. The US jobs data expected to be near the recent averages and hourly earnings growth may slow. 

Italy:  

What has been an internal debate in Italy will now become an external confrontation with the EC over the trajectory of fiscal policy. There may be leeway than displayed by the knee-jerk reaction of investors and the tut-tutting by many economists.The beginning point is not that the Italian government projects a 2.4% budget deficit (of GDP) for the next three years. It is that Italy runs a primary budget surplus on average for the past seven years of 1.5% of GDP. The deficit is 0.4% more than the finance minister had indicated was the most he would accept. This is about 7 billion euros on its roughly 1.75 trillion euro GDP. The 3.7% slide in the Italian stock market before the weekend wiped out 24 billion euros. 

Rating Agencies:

There is fear that Italy may be downgraded and at a time when the ECB is winding down its bond-buying program. Moody’s Baa2 rating has a negative outlook, and a decision is likely in October. It seems to be the most likely to cut Italy’s rating.S&P is reviewing Italy’s BBB rating, and a decision is scheduled for October 26. Recall that last October, S&P surprised many with its first upgrade of Italy’s rating in at least 30 years. It may not be in a hurry to say this was in error. Fitch’s BBB rating for Italy was given a negative outlook in August, but it is unlikely to cut its rating soon. It has assumed a 2.2% deficit for 2019 and 2.6% for 2020. DBRS is the fourth rating agency that is used by the ECB. It gives Italy a BBB (high) rating and is willing to tolerate some deterioration of the debt/GDP ratio especially if the external environment remains strong and the fiscal measures boost growth. 

Italian Politics:  

It is not unreasonable that the League and the Five Star Movement insist on implementing the programs on which they had campaigned. The 2.4% deficit projection is not nearly as onerous as some had feared. Although this within the 3% deficit-GDP mandated by the Growth and Stability Pact, it shows a reluctance to adhere to the 60% debt cap rule. Power lies with the two deputy prime ministers, who had been outmaneuvered in naming the finance minister. The centrist-bloc of the President, Prime Minister, Finance Minister, and Foreign Minister are on the defensive. A resignation by the finance minister would be another blow to investor confidence if it comes to that. Di Maio and Salvini appear to be looking forward to European Parliament Elections next spring and must deliver the goods. The issue is whether tax cuts and a “citizens wage” will help boost growth or whether it will be more than offset other factors, such as higher interest rates, the loss of business confidence and weaker international trade environment. On the other hand, the left appears demoralized and without a clear alternative.