16 Jul 2018
Ultimately, we think Italian politics will be constricted by reality, and we therefore want to be involved at the right levels.
The emergence of a new Italian populist coalition government was a major source of market volatility in May and prices have adjusted to take account of this less certain backdrop. In this post I wanted to briefly recap what happened, show the market reaction and to ponder the future a little bit.
Two months after an inconclusive general election on March 4th (in which no single party won a parliamentary majority), the populist Five Star Movement (M5S) and the anti-immigration League (La Lega) announced in May that they had reached an agreement to form a coalition government based on an agreed program called “Contract for the government of change”.
The Contract contained a number of spending commitments that if implemented, would result in a significant increase in the government deficit and a marked deterioration in the country’s debt profile. These included the M5S’s wish to implement a minimum citizens’ income and La Lega’s desire for a flat tax. Both parties also stated their wish to repeal an automatic increase in VAT scheduled for later this year.
According to estimates from the Osservatorio per i conti pubblici italiani, combined, the commitments contained in the Contract would cost 6-7% of GDP. This extra spending would see Italy fall foul of the Fiscal Compact which commits Italy to tight fiscal restrictions given its greater than 60% debt/GDP ratio.
With Italy’s debt ratio already above 130% of GDP, and its credit rating at the weak end of investment grade (S&P BBB-, Moody’s Baa2, Fitch BBB) any further deterioration in Italy’s public finances could create real anxiety amongst investors. (The ECB can’t buy securities rated sub investment grade by all three agencies as part of its monetary policy objectives).
As a result of the new political backdrop and associated risk, Italian risk premiums have risen. The 2-year Italian government bond (BTP) yield rose from -17bps at the end of April to a peak of 2.7%, before settling at around 70bps at the end of June. (For context, at the end of June, Greece 4.75% 2019 yielded 1.0%. and Portugal 2020 yielded -12bps). The 10-year BTP yield rose from 1.8% in early May to a peak of 3.1% before settling at 2.7% at the end of June. The price change on the 2-year BTP was obviously more modest (it fell from 101 to 95.4 before recovering to 99) but the 10-year BTP is still about 8 points lower.
Italian credit was also hit. Wind Telecom for example now trades in the low 80s and Unicredit and Intesa’s Additional Tier 1 (AT1) bonds now yield between 6 and 7% (yield to call, euro hedged).
At face value, the new coalition government is preparing for a material deterioration of Italian public finances and by doing so is on course for a showdown with the EU.
But of course, political realities must also be considered. First is the fact that the coalition is weak. It is a combination of unlikely bedfellows who had never previously intimated their desire to work together. Theirs appears to be a marriage of convenience, not a meeting of minds. Neither does the new government enjoy a strong parliamentary majority (its majority in the Senate is only 6 seats). The Italian President is also unusually powerful and able to block legislation on constitutional grounds. Second is the fact that the new government’s ability to spend is severely restricted by the economic realities. Any material increase in spending which threatens a credit rating downgrade and raises risk premiums further will quickly hurt Italian residents who own two thirds of outstanding BTPs and threaten a crisis which would undermine the economic recovery. How far does the government want to push it?
In other words, whilst investors can expect a more conflictual approach and a stepping up of anti-EU rhetoric, the coalition knows that it must also tread carefully and that its economic options are quite limited. For example, whilst the government scored a recent victory in relation to the migrant issue (where its stance seems to be chiming with voters), the coalition’s attempt at even installing an anti-EU economy minister was thwarted.
We therefore wait to see what happens next. We can expect Italian assets to be more volatile and the rise in risk premiums is appropriate. Some increase in spending is quite likely, but there is also the prospect of the collapse of the coalition and potentially new elections. And given that M5S and La Lega are the most anti-EU of all Italy’s parties, if this coalition were to fall, then what comes next may well be more moderate.
In short, we ultimately think that the politics will be constrained by reality (as the Tsipras government in Greece quickly discovered) and therefore we want to be involved at the right levels. This expresses itself differently in different funds but in principle we will be likely looking to take risk rather than to reduce it.
Lewis Aubrey-Johnson is Head of Fixed Income Products at Invesco Perpetual.
Investment risks
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Important information
All data is as at 30.06.2018 and sourced from Invesco Perpetual unless otherwise stated.
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