Close on the heels of a disappointing GDP report in Q2, Italy is set for a contraction in GDP this summer as well, as there seems to be a genuine slowdown in the Italian economy in the run-up to the referendum, reports Bank of America Merrill Lynch. Chiara Angeloni and Gilles Moec point out in their August 19 research piece titled “Zero growth was no fluke” that Italians have turned more optimistic since the end of 2012.

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Italy’s soft and hard data divergence

The BAML analysts point out that investors’ attention in Europe has shifted to Italy after Brexit.

Last month, Societe Generale’s Albert Edwards echoed similar views when he wrote: “Brexit was an issue in the rear view mirror… In the aftermath of the Brexit vote, there is an increasing fear of other dominoes falling within the heart of the EU… Italy is bleeping very loudly on most people’s radars with its banking crisis and impending referendum seen as leaving the country on a knife-edge.”

After tracking Italy’s recent data, Angeloni and Moec point out that the Italian economy stagnated in Q2. Pointing out the divergence, the BAML analysts highlight that Italy’s soft data points (such as PMI, European Commission surveys) were surprisingly decent in Q2. Though these soft figures fueled hopes that the figure for the spring GDP was just a fluke, the BAML analysts don’t believe so. They note hard indicators won, with industrial production declining 0.5% qoq in the second quarter, wiping out the positive growth witnessed in the first quarter. The analysts attribute the decline to the drop in production of durable consumer goods and investment goods.

The BAML analysts point out that the downbeat message from the hard data stood at odds with the levels of sentiment indicators. They note that business and consumer sentiment indicators from Istat and the European Commission dropped only marginally in Q2 against the average level posted in Q1 and 2015. They highlight that the whole set of indicators remained well above the long-term averages, which is normally consistent with positive data.

Italy, GDP Contraction Confidence indicators

Italy’s optimism surge not matched by actual private consumption

Upon investigating the relationship between the surveys and real activity data, Angeloni and Moec found that the divergence between soft and hard data derives from a shift in confidence. They state there has been an “optimism shock” and that Italians have now become more optimistic since the end of 2012. They believe the combined effect of the ECB’s “whatever it takes” and a political clarification after the end of Monti’s government could be the reason behind the “optimism shock.” However, the BAML analysts point out that the spectacular surge in optimism was not matched by actual private consumption, which has improved only modestly.

Confidence take-off

The analysts argue that the Italian government has lost a lot of popularity recently and that the issues in the banking sector have eroded confidence. However, the BAML analysts believe that at this stage, the “optimism regime change” of late 2012 hasn’t been eroded.

Expressing concern over Italy’s weak economy, Knowledge Wharton highlighted last month that Italy’s banks have a very high rate of shaky loans at about 18%. The report noted that a potential failure of Italy’s banking system might require a state rescue at a time when the country is already heavily indebted at around 135% of GDP.

Meanwhile Italy is preparing for a constitutional referendum in October, and rating agency DBRS placed Italy’s last “A” credit rating on review, citing uncertainty about the referendum.

As the data releases have mostly all driven the GDP tacker lower, Angeloni and Moec at BAML believe it is quite possible that the referendum campaign in Italy will start in earnest in a deteriorated macroeconomic context.