Market Comment – Italy: a stone in Europe’s boot

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The drama around the populist Italian government and its budget are expected to continue to fuel market volatility in Europe. We suggest holding on to any exposure in Italian bonds and remain negative regarding European equities and the financials sector.

Once again, European markets are in the spotlight because of political risk. Uncertainties regarding the outcome of negotiations on Brexit and on the Italian budget are rising. The latter constitutes the biggest risk for European financial markets, as the credibility of Italy and, more broadly, of the eurozone institutional framework, is at stake.

A story of good and bad news

Let’s start with the bad news. As stated by institutions such as the International Monetary Fund, Italy is suffering from slower growth compared with the eurozone because of low productivity and a high level of debt. For example, Italy’s EUR 2,300 billion in public debt represents 130% of GDP. Nonperforming loans are high, and Italian banks own 20% of Italian sovereign debt.

But there is also good news. The Italian economy is big and the third largest economy in the eurozone, with a GDP of EUR 1,700 billion. Italy also has a positive current account surplus that is 2.8% of GDP.

Several takeaways can be deduced:

  • The power of Italy to negotiate with the European Commission (EC) is much stronger than that of some other countries, such as Portugal, Spain or Greece. This strength implies that discussions could be tough in the coming weeks between Italy and the EC.
  • Any significant increase in Italian interest rates will generate financial tightening for the Italian economy, worsening the economic outlook for 2019.
  • Any increase in Italian risk premiums will generate pressure on the share price of Italian banks, given their exposure to Italian debt.
  • Given Italy’s size, the eurozone’s exposure is substantial. Moreover, eurozone banks also have a significant exposure to Italian sovereign debt. As a consequence, any significant stress on Italian assets will spread through eurozone financial markets.
  • As long as eurozone political risk remains high, it is very likely that the great divergence between European and US markets will persist.

Market volatility to continue

In the coming weeks, we expect that markets will be uncertain and that volatility is likely here to stay. The most recent headlines related to the Italian budget are a good example. There was turmoil when a budget that did not meet the EU’s guidelines was introduced, followed by some relief when this situation was said to be reversed in 2020. The back and forth is fueling market unease. Such uncertainty is expected to continue to feed the ongoing underperformance of Italian equity markets, the European banking sector and, more broadly, the underperformance of the European stock market compared with the US. (See Figure 1.)

No crisis, but caution and patience are required

Given that several backstop measures has been put in place, we do not anticipate a new European crisis comparable to the one of 2011-2012, when Italian ten-year interest rates reached 8%. But given the expected market volatility, we are comfortable with our negative views on European equities (compared with US stocks) and the financials sector versus other sectors.

We recommend retaining any exposure to Italian sovereign bonds. We believe that there is little doubt that Italian bonds will be redeemed in euros and that their very attractive yields will be realized in the end. A euro crisis, let alone a euro break up, is unlikely.

Italian populists are aware of the huge costs of an exit from the euro, and politicians know that few Italian voters are willing to bear the cost of such an event. Instead, we believe that a bluffing game is underway to increase Italy’s bargaining power. The current volatility in Italian bond markets is actually one of the factors that is already pushing Italy back towards the EU’s budget rules. Bond markets and the credit-rating agencies, that are conducting reviews towards the end of October, are a combination that have proven powerful enough to convince at least the leader of the League party, Matteo Salvini, to pull back.

We believe that Italian spreads will likely keep trading between 200 to 300 basis points, with the risk of further spikes. It will take some patience, however, before spreads are again below 200 basis points, which is a level at which we would consider scaling back exposure to Italian sovereign bonds.

Olivier Raingeard, Global Head Equities
Chris Huys, Senior Fixed Income Porfolio Manager