The Italian government is fighting a war on two fronts.
By proposing a budget heavy on debt-fuelled spending, the country started clashes both with the European Commission and with the market.
Neither has confidence in Italy’s projection that its economy will grow at a rate of 1.5 per cent, or that its current debt path is politically and financially sustainable.
Longer term, a pessimistic debt market risks raising the cost of funding for the real economy, potentially creating a negative feedback loop.
Return of the spread
The market has punished BTPs and Italian equities.
Italian government bonds have underperformed versus other peripheral markets and the BTP-Bund spread continues to widen. The yield on the 10-year Italian benchmark bond reached 3.75 per cent in October, rising to levels last seen in 2014. Similarly, the spread between 10yr BTPs and German Bunds has recently traded as wide as 340 basis points, the highest since early 2013, and close to the 400-basis-point level that Italian officials indicated as their ‘pain threshold’.
Investors are reassessing Italy’s political and macro outlook, as well as the effect that a higher deficit will have on BTP supply. Market logic holds that higher borrowing and expected bond issuance will come at a time when the European Central Bank is reining in its asset purchase programme, removing support to European government debt.
Italian equities did not fare much better. The FTSE MIB index is down 22% since the peak in May, with banks, telecoms and businesses exposed to the domestic economy taking the biggest hit.
The market is pricing in a grim outlook, indicating a 12 per cent chance of a default over the next three years. Prices also suggest a 24 per cent chance of debt restructuring, with a 30 per cent haircut, over that time period, according to crude calculations using Italian CDS contracts. Neither event is likely in our opinion and show just how negative investor perception has become.
Similarly, redenomination or ‘Lira’ risk, priced into CDS contracts, has spiked in the last few weeks in tandem with short-dated Italian yields.
The price reflects very negative scenarios, in our view, and the outlook could brighten considerably if the Italians show some flexibility in budget negotiations.
Source: Fidelity International, Bloomberg, 19 October 2018. Lira risk spread premium takes the difference between 2014 and 2003 Italy 5-year CDS and is a measure of re-denomination risk. Under the 2014 CDS contract payment in any currency other than EUR is a credit event, whereas under the 2003 CDS contract a re-denomination is not a credit event.
Source: Fidelity International, Bloomberg, October 2018
Debt and growth dynamics
At 132 per cent of GDP, Italy’s debt stock is one of the largest in developed markets. It’s a key weakness because it makes the country more sensitive to market and growth shocks.
Italy has tried to reduce its debt pile over the past few years, with limited success. Previous governments have run a large primary surplus, above the Eurozone’s average, aiming to reduce the debt to GDP ratio to a more manageable 120 per cent by 2020.
The new government’s stance, favouring deficit-funded spending, tax cuts and transfers over structural reforms, is in contrast to the trends seen in the past decade. The deficit trajectory is expected to worsen. The new target deficits of 2.4 per cent, 2.1 per cent and 1.8 per cent over the next three years break from prior plans of returning to a budget surplus by 2021.
We also note that, absent any strong automatic stabilisers, the deficit targeted by the Lega Nord/Five Star coalition is a best-case scenario, based on very optimistic growth assumptions of 1.5 per cent on average over three years. It is unlikely, based on the budget composition and standard spending multipliers, that such growth levels will be achieved. Judging by the latest, softer than expected PMI releases, the outlook for Italian growth remains challenging. Even a minimal slowdown in GDP growth would set the country’s debt to GDP ratio back on an upward trend.
Source: Fidelity International, Haver Analytics, OECD, October 2018
A rating downgrade is in the price
From a political point of view, no government is an island, particularly in the Eurozone. Italy’s disregard for fiscal discipline is in contravention of the Stability and Growth Pact and sparked a negative reaction from the European Commission, which rejected the budget and called the deviation from targets ‘unprecedented’. Talks will continue in the coming weeks but the tone is unlikely to change, with the Italian authorities keeping a confrontational stance.
The Commission is not alone, rating agencies have also expressed concerns over Italian finances. Moody’s cut Italy’s sovereign rating by one notch, citing the shift in fiscal strategy and lack of structural reforms.
A similar move is expected by S&P on October 26th. We would argue that the rating downgrade is already priced in, and so a relief rally is possible on the announcement itself. However, it will be short-lived if the Italian government maintains its aggressive rhetoric.
A downgrade to high yield would have a seismic effect both on bond markets and the European economy. While this is neither our base case or market consensus, the market may start to price such an event in given the severity of the potential outcome.
Lastly, the foreign ownership of Italian government debt has fallen considerably in recent years, declining from 40+ per cent in 2010, to around 30 per cent now. The larger share of domestic investors should provide some support to Italian government bonds, although buyers would still be influenced by sentiment and long-term sustainability considerations. There will also be less support from the European Central Bank, which will limit purchases to reinvestments. Net supply will have to rise to finance the government’s plan, putting further upward pressure on yields.
Watch for contagion
From a financial point of view, the market for Italian government bonds is an island. So far at least.
We have observed very little spill over into the other peripheral government bond markets and minimal contagion in Italian corporate bonds.
The spread between Italian and Spanish 10-year yields has widened considerably since the beginning of the year, highlighting a relative underperformance of BTP compared to Bonos.
Similarly, European Investment Grade credit has been relatively immune to the moves that have rattled BTPs. Italian investment grade corporate bonds, for example, greatly outperformed Italian government bonds, with over 70 per cent of the bonds in the ICE BofA Merrill Lynch Euro Corporate index issued by Italian corporates currently trading at a yield below that of the same-maturity BTP. While some of this is due to the relative illiquidity of BTPs compared to corporate debt, investors are also taking the view that companies with international revenues are a safer bet than the country in which their headquarters are based.
While this evidence shows that only limited contagion has taken place, investors should not get complacent. Other European asset classes will be hit if BTP yields continue to rise. While credit markets have shown that they can be a safe haven in periods of high BTP volatility, selectivity is still paramount.
Source: Fidelity International, Bloomberg, October 2018
Source: Fidelity International, Bloomberg, October 2018
Banks are (once again) the nexus with the real economy
Italian banks are the conduit of volatility from financial markets into the real economy.
They have a large government bond exposure, and are therefore sensitive to changes in sovereign yields. On the other side, the Italian corporate sector, which contains many small and medium sized companies, is more heavily reliant on banks than on capital markets for funding.
Spread and GDP expectations feed directly into calculations for banks’ borrowing costs and can affect their Core Tier 1 capital levels. Italian mid-tier lenders are still in the process of strengthening their balance sheets, despite making significant progress over the past four years. Higher spreads mean lower NPE (non-performing exposures) disposal prices, and potentially higher losses for banks. The fate of the smaller players is therefore tied to that of the sovereign. The larger national champions, while still volatile, have plumper capital cushions and are better positioned to navigate the turmoil. We are happy to hold to our exposure on the fixed income side, while we have been reducing our exposure to banks on the equities side.
The impact on the real economy has so far been minimal. Banks are yet to pass on the higher funding costs to private and corporate borrowers, and any marginal increase in lending rates has been matched by higher rates on deposits. Should spreads remain at current or wider levels, however, we expect loan rates to eventually rise. Tighter financial conditions will eventually weigh on domestic demand, further challenging the government deficit assumptions and growth ambitions.
We can protect our portfolios by focusing on Italian companies with a broad footprint beyond the domestic borders, as well as non-cyclical issuers in credit with strong balance sheets and national champions in the financial sector with enough liquidity to weather the volatile environment.
Investors won’t be the only ones watching the markets closely.
Italian policymakers will be doing the same, given how dependent their promises are on a pick-up in sentiment and growth next year. They will also keep a close eye on the mood of both the electorate and business community, particularly in the wealthier North, where Deputy Prime Minister Matteo Salvini’s Lega has its stronghold. Any meaningful change in the polls due to the market turmoil could influence the government’s fiscal choices, particularly as the European elections are fast approaching.
For now, however, both Five Star and Lega still enjoy strong support among Italians. As a result, the government will keep fighting on the financial and political fronts, with more clashes, headlines and volatility to be expected in the quarters ahead.
1 Source Bloomberg, as at 22/10/2018
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