Graphic content; Italy continues to trade cheap to other Eurozone assets
28th March 2019
We last wrote about Italian sovereign bonds in October 2018, when we highlighted that the market was overreacting to Italy’s deficit story, and overestimating the probability of an Italian default. Since then, while Italy 10-year yields are 1% lower, Italian sovereign bonds have continued to trade cheap versus other Eurozone sovereigns. In fact, comparing Italian sovereigns with European high-yield corporates, the differential is the same today as it was in the depths of the Eurozone crisis – a time when the Eurozone was on the brink of collapse.
We continue to believe that the market’s concerns over Italy’s ability to meet its debt-servicing costs are completely overblown. It takes time for higher spreads to have a large material impact on debt-servicing costs. Yes, Italian government debt levels are high, but there was nothing new to cause spreads to jump higher last year – Italy’s government debt to Gross Domestic Product (GDP) is lower now than it was in 2015, and has seen among the smallest increase in developed market governments, only around 25% higher than 20 years ago. Much of this debt is either held by domestic investors or the European Central Bank (ECB)/Banca D’Italia, and so we expect ownership to be relatively stable.
The market’s Italian concerns a year ago surrounded the possibility of 5 Star forming a coalition government and taking Italy out of the Eurozone. In the autumn, the market’s concerns revolved around a higher-than-permitted proposed budget deficit – but these risks were taken off the table in Q4 last year. An election, were it run today, would likely strengthen the Lega Nord, and would actually in all likelihood be positive for Italian assets.
We wrote last time that the Italian budget deficit was not massively out of line with other Eurozone governments. The Italian economy did approach recession territory late last year, which was negative for the budget deficit. However, at the same time we have seen forecasts of other Eurozone budget deficits increasing, such as France’s following the Gilets Jaunes protests. French government debt to GDP is 100%, but unlike the original response to Italy’s rising budget deficit, French 10-year spreads over bunds are now below where they were when the Gilets Jaunes protests started. Furthermore, at least over the short to medium term, it could be argued that continued Eurozone economic weakness might support Italy, assuming that economic weakness prompts additional monetary stimulus from the ECB.
We continue to believe that as investors begin to realise that the previous concerns were overblown, Italian yields should normalise with other peripheral Eurozone sovereign bonds, converging towards Spain.