Credit Impulse Update: Italy
Investors are perhaps overly concerned by the upcoming presentation of the Italian budget, but a look at our credit impulse indicator shows that the country still faces very real economic risks.
Fixed Income Specialist, Saxo Bank
The human mind works in mysterious ways. Sometimes we see beyond things, while other times we cannot see things at all and continue to make the same mistake over and over. A great example comes from the Flat Earth Movement, which has of late begun to entertain the idea that Australia does not exist. Are any of your mates Australian? Well, you will be shocked to know that, in reality, Australians are computer-generated personas.
Speaking personally, I have just had to face the realisation that my Sydney-based Saxo colleagues are fact simply Denmark-based people who enjoyed telling lies about white sand beaches and kangaroos.
This conspiracy theory might sound extreme, but it’s a good example of a much broader phenomenon. Although we can see and touch our Australian friends, and can even fly to Australia, some people still believe that it’s all a colossal fake. I believe that this is what we have seen happening in financial markets for some time now, and although investors are seeing clear signs of distress in the bond market, they are still holding on to their investments in the hope that things will settle down and evolve as they have done over the past few years.
Unfortunately, things are different now. Although central banks remain a big presence in financial markets, their policies will not be enough to support valuations in the fixed income and equity markets as political uncertainty continues to intensify.
Although trade war is now the most obvious risk that investors are trying to price in, it seems that European investors have quickly forgotten about the shivers that Italy sent to the market when its politicians seemed unable to form a new government just over a month ago.
These shivers, which had a great deal to do with the fragility of the European Union in the face of a populist, eurosceptic government in Rome, appear to have receded from many investors’ minds and plans. Last weekend’s municipal elections, however, show that the populists are gaining ground and strengthening their position in Italy.
There is precious little reason to imagine that anything has really calmed or returned to ‘normal’.
One could easily call the results of the municipal elections’ second round extraordinary: the city of Terni, which has been a left-wing municipality for 20 years, has now passed to the right-wing League. The cities of Imola and Avellino, which were also governed for 70 years by the left-wing party, have now elected a candidate from the populist Five Star Movement.
Siena, which is home to Banca Monte dei Paschi di Siena bank, has also historically a left-leaning municipality. Now that a member of the right-wing coalition has been elected, however, uncertainties concerning the bank’s stability are on the rise.
The League is the clear winner of the second round of municipal voting. It seems that Interior Minister Matteo Salvini’s ‘Italians First’ approach and hard line on immigration is winning Italians over. The right-wing party won 42 out of 109 municipalities; before the vote, it only held power in 23. The biggest loser is the left-wing party, which used to have 57 municipalities and now has only 31.
These municipal elections are extremely important because they have confirmed the undisputed majority of the Five Star Movement and League parties, both widely recognized as eurosceptic. We can expect these parties to try to advance their policies and brush against the public debt reduction question as we approach the 2019 budget deadline this autumn.
More volatility ahead for Italian sovereigns
As we get closer to the approval of the 2019 budget, we expect volatility to hit the short part of the Italian sovereign curve the hardest. As you can see on the chart below, the 2011/12 debt crisis saw two-years Italian sovereign yields spike faster than their 10-year counterpart, and we believe that this could happen again if investors perceive higher risks related to debt repayment.
Longer maturities will also react to volatility, but we expect them to be more resilient due to the fact that investors are going to perceive more immediate risk in the repayment of short-term maturities.
Another area of caution is the subordinated debt from domestic Italian banks such as Monte dei Paschi, Ubi Banca, Banca Carige, and Banca Popolare. MPS is of particular concern as the bank is now more exposed to policies set by the new populist Italian government. The Italian lender was mentioned by both the Five Star Movement and League in their campaigns, as they believe that the state-owned bank should better serve the Italian people. As a consequence, MPS subordinated debt issued in January this year with maturity in 2028 has widened by 560 basis points since issuance, hitting a high of 11% in yield last week before the second round of the municipal elections.
The only headlines that could have a positive impact on the Italian lender are those concerning a potential acquisition, which seems to be under consideration by Credit Agricole. We believe that if an offer comes from the French lender, the Italian government will prove inclined to sell its share in MPS as it would be then able to invest more resources into the policies at core of their political agenda.
We remain constructive on the subordinated and senior debt of bigger Italian lenders such as Unicredit and Intesa Sanpaolo, which are well-diversified internationally with large but limited exposure to the domestic Italian market. We believe that already now senior and subordinated debt of the two banks offer interesting returns, but we should see better buying opportunities as we get closer to the 2019 budget approval in October as credit spreads should widen further in light of public debt talks.
Finally, volatility in Italy most likely will spread to the periphery with Greece and Spain being the most probable victims. At the same time, we believe that Portuguese debt will continue to be quite resilient to Italian news as the nation continues to demonstrate that it has overcome the European debt crisis of 2011/2012.