Five months is a long time in Italian politics. Back in June, we observed that Italy was too big to fail, but also too big to bail. We were also waiting for the almost inevitable clash with the European Commission over the budget. That has now arrived and we have started trading Italian risk in the new higher range for spreads.
* (Bubbling Tensions in Politics)
Italy has been at the forefront of political risks in Europe this year following the March elections. More recently, Italian government bonds (Buoni Poliennali del Tesoro or BTPs) tumbled in October. That triggered a sharp widening in yield spreads over German bunds. The compensation for holding Italian risk is now higher than at any stage in the last five years. Against that backdrop, we recently decided on the Asset Allocation team to add Italian sovereign risk to our dynamic portfolios.
We do not want to downplay the risks. The ongoing confrontation between the Italian government and the European Commission over the budget could lead to fines and even a denial of voting rights. The tensions within the governing coalition could escalate to the point that an early election becomes inevitable. Over the longer term, there are serious questions about the ability of Italian government finances to weather the next recession.
The question is not whether Italian government bonds are risky. They are. It is whether there is now adequate compensation for taking exposure to that risk. By a wide margin, Italy is now the cheapest investment grade-rated sovereign. With that in mind, are there reasons to be more sanguine about Italian risks?
The Italian constitutional barriers to irresponsible fiscal policy have proven flimsy. But so far, the coalition government hasn’t actually spent much money. Their budget deficit for 2018 is currently coming in smaller than over the equivalent period in 2017. The ongoing debate, therefore, is all about future spending intentions and the credibility of Italy's economic and fiscal forecasts.
The nature of the funding situation in Italy is also different to that seen in the Eurozone debt crisis of 2011-2012. Seven years ago, large external imbalances across peripheral Europe were exposed when international capital inflows dried up. At the time, the entire 'periphery' had large current account deficits: Spain (4% of GDP), Italy (3.5%), Portugal (6%), and Greece (10%). Today, however, Italy is running a surplus. This means that it doesn’t actually require funding from overseas; it just needs to convince Italians to keep their money at home.
We therefore believe that the Portuguese experience from 2015/16 represents a much better template. Their draft budget in January 2016 was rejected by the EU as representing a “significant deviation from European fiscal rules”. In that instance, Portugal blinked first and submitted a revised budget less than a month later which calmed the markets.
On paper the two situations look pretty similar. In 2016, Portugal had debt at 129% of GDP, an initial budget proposal of 3% based on unrealistic growth assumptions and no external funding need. Today, Italy has debt at 132% of GDP, an initial budget proposal of 2.4% of GDP based on unrealistic growth assumptions and no external funding need.
The difference this time around is that Italy is too big to fail, and knows it. The coalition government's rhetoric has been belligerent, with the European Commission described by Deputy Prime Minister Matteo Salvini as “the enemies of Europe sealed in the bunker of Brussels”.
A unilateral capitulation from Rome is unlikely. But ultimately, Europe has a trump card up its sleeve. If the situation escalates to the point at which Italy’s sovereign rating is downgraded to junk, the country could find itself ostracised by the European Central Bank (ECB).
In that scenario, BTPs would be excluded from the reinvestment flows expected from the ECB’s mammoth asset portfolio and become ineligible for use as collateral by Italian banks without an expensive waiver. The Italian financial system would be at risk of collapse.
Given that both sides have leverage in this dispute, we should expect a serving of that delicately crafted confectionary: Brussels fudge. Before pushing the Commission to the brink, Italy will have to think hard about the consequences of a junk rating. Before cracking down too hard on Italy, the Commission’s collective mind is likely to be sharpened by the emerging signs of contagion in other peripheral markets.
In our view, a compromise is the likely outcome. That will probably involve the Italian government moderating its growth forecasts and turning its deficit targets into a ceiling alongside a binding commitment to take corrective action if needed.
Taking all that into consideration, we are happy to buy Italian risk on bouts of weakness today. The path ahead will undoubtedly be rocky and no-one should be under the illusion that Italian debt is a safe asset. But we believe the compensation for risk is starting to get compelling.
Risks abound, but opportunity knocks.
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