BONDS 8 minutes to read

Europe divided – trick or treat?

Althea Spinozzi

Fixed Income Specialist

Summary:  Threats of trade wars, the Brexit crisis, Angela Merkel's impending departure and the ghoul of recession, mean there's much to spook us this Halloween. However, though Italy may be a mess its debt seem worth a look.


It's finally that time of the year when I can pull out my Halloween costume to terrify friends and colleagues. This year I will be a Graveyard Market. For those who are not familiar with the term, a graveyard market occurs when investors can’t sell without suffering large losses in a bear market, while others decide it is better not to invest at all. 

Spooky, right?

I can totally see how tonight’s party will play: in the room there will be a bunch of people dressed up as interest rates, always laying low in a corner, while others will be dressed up as bulls, stimulus and debt bonanza. Only when my group of friends dressed up as the flattening yield curve, trade war and recession come in will I make my grand entrance and win the prize for the best Halloween costume of 2018.

Sounds familiar right? Well it seems that under current circumstances it is not necessary to have a disguise in order make people realise that things are finally looking bad and that maybe soon they will turn even worse.

Pressure has been piling up since the beginning of the year. The threat of a trade war has not yet been resolved, emerging markets are walking a fine line, and in Europe we have Brexit negations going nowhere, while the region's  third largest economy is taking a hard line against the European Union, making many believe that a new crisis in the periphery is more likely, or worse still, that the EU it is just falling apart.

Despite everything, things seemed to be sustainable until this week when suddenly, two events occurred that will inevitably collapse this big house of cards of overpriced assets.

Angela Merkel will not run as chancellor again

This news will destabilise the entire European Union. The worst thing is not that Merkel is due to finish her fourth and final mandate in three years time but whether the market will be able to endure a prolonged period of  uncertainty about who her replacement will be.

The real risk here is that Merkel will not survive till the end of her term and that early elections will take place as soon as the CDU gets a new boss. And as German voters have been vocally complaining against Merkel’s immigration policies, a very likely scenario would be that next chancellor is a conservative. Many are pointing to Friedrich Merz as a probable candidate, a member of the CDU who has coined the idea of “Leitkultur” which means “lead culture”, which calls on Muslims immigrants to absorb Germans values and traditions.

If Germany turns conservative than agreement with other European countries would become more and more difficult, and it would pose the biggest threat to the EU since the second World War.

S&P gives negative outlook to Italian sovereign debt, but does not yet downgrade the country

Many people believe that it's great that Italy has dodged the downgrade bullet. For now. However, I believe that S&P's decision to wait on a possible downgrade will give the current government more reasons to continue with their populist policies. And this is what is already happening now. GDP figures for the third quarter of this year came out lower than expected yesterday, signalling that the Italian economy is stagnating and alarming the current government.

The economic expansion of 1.5% forecast by the minister of finance, Giovanni Tria, looks impossible already and many politicians are starting to suggest that more public investment is necessary in order to avoid another recession. This not only implies that the Italian government might consider an even deeper deficit than that already proposed for 2019, but that at this point it is clear that the Debt/GDP figure of 131.5% will be hard to contain.

Risks are high but opportunities are still out there


As we explained in our trade idea published last month, we believe that there is plenty of reason for Italian BTPs to continue to fall. I believe that by the end of the year we’ll see the BTPs hovering around the 4% level, giving an opportunity to investors to realise that Italian corporate debt and has significantly repriced since the beginning of the year.

We particularly like Italian financial debt of large banks with international operations such as Intesa San Paolo and Unicredit. The yields of subordinated debt of these companies have almost doubled since the beginning of the year as foreign investors fled the Italian market, worried that banks' large exposure to Italian BTPs would negatively affect the balance sheest of these institutions. We believe that this is an issue particularly pressing for smaller banks, while for larger banks, which in the past five years have worked towards a diversification of their balance sheets through involvement in the European and American markets, are in a good position to mitigate losses deriving from volatility in the BTPs.

Just to give you an idea, the average yield to worst yield on a Unicredit subordinated perpetual bond rose from approximately 4% to 8% YTD, and also the price of certain senior unsecured bonds of the issuer fell from par to the low 90s giving in some cases a return of nearly 3% for five years' maturity. Given the low yield scenario we  have the European space the decision to grab some juicy returns from the Italian misfortunes clearly becomes more appealing.
Figure 1: Italian 10-year sovereign bondyield.

On the other hand, we believe that uncertainty about German's leadership will bring more risks than opportunities in the European sovereign space in the short run. 

German Bunds started to rise as news emerged that Merkel would not pursue another mandate. Things have stabilised now, however, we cannot forget all European sovereigns at the moment are pricing over German Bunds and that if this benchmark is to reprice there would be serious consequences for all European sovereigns. 

Unfortunately, it is hard to see any opportunity in this space at the moment. After all, yields remain at record lows and it is exactly in moments like this that keeping some liquidity aside may pay off later. 

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