14 Oct 2018
The latest news on the Italian budget news is disappointing but not wholly surprising. The new Five Star Movement – League coalition government took office in June with a populist mandate. Both parties, headed by Luigi Di Maio and Matteo Salvini respectively, have at times employed hostile rhetoric towards the EU and espoused spending and tax-cutting commitments that if met in their entirety, would bankrupt Italy. Put in that context, the recently announced 2.4% deficit target over the next three years is not calamitous in and of itself and is only roughly 0.4% above where most analysts had expected the budget to settle on.
So what’s the big deal? Firstly, recent comments – especially from the relatively market-friendly Finance Minister Tria – suggested that the deficit would likely be in the region of 1.6-1.9%. This had lured the market into thinking the budget outcome would be friendly, causing investors to increase their positioning in Italian government bonds over recent weeks. Hence when the adverse news was released, many investors were caught offside and had to sell: our own market intelligence suggests that BTP volumes were particularly high last Friday. Secondly, the announced budget plan has an important signalling effect in that it represents a big win for the populists and undermines FM Tria’s credibility. Thirdly, it sets the Italian government up for confrontation with the European Commission over coming weeks and months and the possibility that Italy will be placed under an excessive deficit procedure. The fact that the deficit target remains at 2.4% for the next 3 years with what many see as unrealistic growth assumptions, betrays the fact that there is no real attempt at fiscal consolidation in keeping with EU rules. Finally, the prospect of ratings downgrades by both S&P and Moody’s later this month has increased significantly.
So what next? We should expect the volatility to continue over the next month with more headlines expected. The full details of the budget are yet to be released, let alone submitted to the EC. There have also been rumours that Fin Min Tria may resign, an event that would not be taken well by the market – at least initially. While all this sounds quite negative, it is far too premature to conclude that Italy’s debt profile is now on an unsustainable path. The sharp unilateral rise in Italian bond yields is a signalling mechanism itself, one that the authorities can only go so far in pretending to ignore. At some point – and if the rise in yields is sustained – the expansionary fiscal policies will become self-defeating as any growth dividend from the fiscal stimulus will be more than wiped out by higher debt-service costs. In other words, and although there is no sign of it yet, market pressure may ultimately put a check on this government’s populists ambitions.
As investors, we have to view the evolution of fundamental news in the context of market valuations. The spread between the 10Y Italian bond yield and Germany’s has already risen sharply to around 300bp, a level not seen since 2013. In price terms, the 10Y bond has fallen by just over 4 pts since its closing level on Sept 27. While not seeking to trivialise these moves, they have been exacerbated in part by investors being wrong-footed as mentioned above. It is also encouraging that there has thus far been very few signs of this news spilling over into other markets in a meaningful way. Unlike previous crises in the Eurozone peripheral government bond markets, Spanish government bonds have barely flinched over recent sessions. Similarly, Italian corporate bonds have for the most part held up reasonably well. In some of our funds, we have been opportunistically buying Italian government bond exposure following the sharp falls over recent days. The Italian newsflow obviously needs to be monitored closely but as things stand, we are not expecting this to precipitate a wider systemic risk-off episode.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
All data is as at 2 October 2018 and sourced from Invesco unless otherwise stated.
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