Why Italy is Europe's biggest risk factor
Fixed Income Strategist, Saxo Bank Group
Soon enough, however, even the most stone-faced investors will need to acknowledge the decay looming in Italian sovereigns.
Last week, news emerged that a group of countries outside the European Union are looking to support the populist Italian government’s agenda by buying Italian sovereigns. This poses serious questions for Italy’s situation within the EU: is the Five Star/Lega government coming to understand that its intent to establish a minimum salary for poorer citizens and move to a flat tax might be too ambitious to carry forward? Or is this all just a diabolical plan to pave the way for an ‘Italexit’?
It’s hard to say, but it is nonetheless becoming clear that although politicians are quick to say that they do not want to leave the EU, they are clearly trying to forge new alliances and gain more leverage when negotiating terms with Brussels. This could ultimately prove a destabilising factor – not only for Italy, but for the EU as a whole.
The US, Russia, or China?
It seems that Italian politicians have spoken with several countries outside the EU regarding their economic problems, but do any of these represent a realistic hope? It looks unlikely...
The US: President Trump said that if needed, he is willing to buy Italian sovereign debt, but we believe that this is just wishful thinking. By purchasing Italian debt, the US would risk usurping Brussels’ authority and worsening an already-shaky relationship beset by trade war tensions and policy disagreement.
Russia: Minister of European Affairs Paolo Savona seems to have talked with the Kremlin about the possibility that Russia will put a “guarantee” on Italian public debt in case the European Central Bank doesn’t support the country’s plans. This might be the most realistic threat: the fourth-largest European economy finding support from the Western establishment’s nemesis. This could give Moscow a foothold in the EU’s centre. While politically this option makes a lot of sense, economically it doesn’t as it would likely spook investors concerned that Rome’s move towards Russia signals an intention to depart the EU.
China: There has been much talk that Minister of the Economy and Finances Giovanni Tria would ask Chinese authorities to buy Italian sovereigns during his trip to Beijing, but it appears that such speculations were premature. We cannot assume, however, that this proposal or similar was not at least floated behind closed doors.
Speculation aside, it is important to highlight that the EU has still the upper hand as under the Public Sector Purchasing Program, the ECB holds €356 billion EUR of Italian BTPs. It is unlikely that the bank would remain on the sidelines were Italy to find another buyer of Italian sovereigns; not only would the ECB want to rein in a euro spike, but it would also want to flex its financial muscles in an attempt to prevent other member states from leaving the bloc.
Italian BTPs: reasons to fear the endemic effect
As you can see from the chart below, the 10-year Italian government bond yield was rangebound from 2015 until May of this year, when it broke the upper resistance band. The continuous decline of BTPs suggests that yields will continue to rise to the next resistance level around 4%.
We believe that this target is achievable by the end of this year as things are starting to accelerate in Italy. We have the submission of the 2019 budget in October, populist politicians fighting against immigration, and a possible downgrade from Moody’s by the end of October that would place Italian BTPs only one notch higher than junk.
A sell-off in Italian sovereigns would affect more than the periphery as investor suspicion would also rise concerning other areas like CEE, for example, where populist parties have gained ground and confidence in traditional institutions such as the EU is decreasing.
Wherever there is risk there is an opportunity. The first opportunity I see is in the Italian domestic market. Since the elections in May, the option-adjusted spread for Italian issuers spiked from +90 basis points to +247bps. This is the highest it has been in five years, yet we are in an environment characterised by incredibly low volatility due to the ECB’s huge balance sheet while default rates remain at historic low.
As credit spreads widen in the high yield corporate space, I believe that there are going to be interesting opportunities for investors to buy and hold for the medium term (three to four years).
In the short term, I believe that the biggest opportunity lies in BTPS. The last government made it clear that BTPS are falling. On August 8, BOT with a maturity of 364 days were issued +34.2bps wider (0.679% in yield) compared to the auction in July (0.337%). Similarly, yesterday saw zero coupon bonds (CTZ) with maturity March 2020 issued with an average yield of 1.277%, almost double the previous level for this bond in July (0.647%).
Although bond prices are increasingly soft, demand remains reasonably high; yesterday, CTZ saw demand for 1.87 times the securities sold, showing that real money remains supportive and untroubled by default concerns
This implies that while BTPs are doomed to fall in the short term, once there is more clarity surrounding the government’s intentions regarding the country’s deficit and relationship with the EU, the performance of Italian sovereigns should stabilise. This constitutes an opportunity for investors to enter into Italian names that are already trading at a discount to their European peers.
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