Risk of Forced Sales Averted as BTPs Retain Investment-Grade Status and ECB Collateral Eligibility
Last Friday, Moody’s downgraded Italy’s credit rating by one notch to Baa3. The decision was justified by weakening fiscal strength due to the higher structural fiscal spending planned by the new Italian government, which Moody’s expects to result in a stable debt/GDP ratio of 130% (they previously expected a gradual decline). However, Moody’s changed Italy’s outlook from “Negative” to “Stable”, indicating that risks to the rating are now broadly balanced given the size of the Italian economy, the country’s substantial current account surpluses and household wealth.
On October 26, S&P is also set to complete its review of Italy’s credit rating, currently held at BBB with a “Stable” outlook and following a one-notch rating upgrade on October 27, 2017. We see risks of a further negative rating action on Italy as material, with S&P likely to change Italy’s outlook to “Negative” or even cut the rating back to BBB.
Fitch, which already rates Italy BBB with a negative outlook, recently decided to postpone its rating review of Italy to Q1 2019.
As a result, Italian bonds are now very likely to retain their IG status. This will avert the risk of large-scale forced sales by benchmark tracking investors and ensure Italian bonds retain eligibility for ECB operations, including bank refinancing against collateral and asset purchases under the ECB’s QE program.
Nevertheless, the market reaction to the Moody’s downgrade was muted, with Italian bonds finding only some temporary relief in the decision to keep the outlook stable. A similar reaction is also likely in the case of a one-notch downgrade by S&P as both events appear to have been largely priced in, although Italian bonds could rally if S&P only changes its outlook “Negative”.
As Conflict With the EU Over Budget Rules Escalates, BTP Spreads Over Bunds Continue to Widen
Meanwhile, Italy’s confrontation with the EU has escalated further after the European Commission (EC) asked Italy to submit a revised Draft Budget Plan (DBP) within three weeks. This was after the Italian government failed to provide acceptable arguments to challenge the Commission’s opinion about the risk of a substantial deviation from previous budgetary targets.
In this case, the reaction of the market was decidedly negative, even if the EC decision to reject Italy’s 2019 draft budget was widely expected, considering that it came in the context of a procedure designed to deal with serious non-compliance with existing EU budgetary rules.
The 10y BTP yield rose by 10 bps to 3.59%, resulting in a 15-bp widening of the spread between 10y BTPs and German Bunds to 318 bps. Nevertheless, Italian stocks were only marginally affected as the FTSE Mib outperformed other European equity markets despite a generalized equity sell-off, with banks performing in line with the main index.
Market’s Perception of Italian Bonds Overly Biased by Noisy Italy-EU Confrontation
In our view, the bond market seems to have over-reacted to the new developments in the confrontation between the EU and the Italian government, both relative to equities and to Italy’s fundamentals, even if the rejection of the budget draft of an EU member state is objectively unprecedented.
Indeed, the process that might lead to Italy undergoing an Excessive Deficit Procedure (EDP) by the EU will be long, and will include a number of stages that could delay or even prevent the imposition of sanctions by the EU. Italy’s ongoing breach of EU regulations by the November 13 deadline will probably lead to the EC issuing a new opinion of non-compliance shortly thereafter, which will most likely be presented for debate by the Eurogroup in early December. However, this would still be an opinion on a budget draft—no formal step toward launching an EDP will be made until the Italian Parliament actually passes the Budget by the end of the year.
The first formal step by the EC would therefore be to prepare a new Country Report in February, flagging Italy’s non-compliance with its 2018 debt reduction commitments and indicating similar risk for the following years (Article 126.3 of the EU Treaty). This would pave the way for a recommendation by the EC to the EU Council for opening a formal EDP, which the Council could approve in the Spring, imposing a deadline (usually six months) for the country to correct its deviation. An ongoing non-compliance of a country with the EC and Council recommendation could lead to the imposition of sanctions. However, in the cases of Spain (under EDP since 2009) and Portugal, fines for 0.2% of GDP were issued in August 2016, only to be cancelled soon after as both countries’ governments committed to better cooperation with EU institutions. Nevertheless, as of today, Spain still remains under EDP.
Furthermore, the 2013 Fiscal Compact mandates that countries under EDP must enter an Economic Partnership Program with the aim of increasing the EU’s oversight on the country’s convergence towards budgetary targets set with the EU. As a result, the process further postpones the risk of a country being subject to sanctions, which could total up to €3.6 billion in Italy’s case.
Finally, ongoing negotiations between the EC and the Italian government over the upcoming vote on the EU’s own multi-annual budget may affect how the EU actually proceeds to correct Italy’s deviation from previously agreed-upon budgetary targets. Italy has already expressed reservations regarding a planned increase in member state contributions, as well as cuts to funds for investments and agricultural subsidies. Also, a decision by the EC to recommend an EDP on Italy could be delayed by next year’s European Parliamentary elections due on May 23-26. The next European Parliament will be the first ever with powers to name the President of the EC among a list of candidates put forward by the various parties and groups, which will require a valid majority of votes to be elected. This reduces the power of national governments in appointing the Commission, requiring agreements between the traditional parties and emerging populist movements, whose representation is expected to increase significantly according to the polls. Merkel wants a German president for the EU to follow Jean-Claude Juncker, and she will need support from Italian populist parties. This could result in a delay of any EDP-related decision until a new EC is formed, which could be less strict regarding the enforcement of EU budgetary rules.
Figure 2: Reversing Austerity Will Slow—Not Derail—Italy’s Debt/GDP Reduction
|Old fiscal targets||2018||2019||2020||2021|
|Nominal GDP growth||2.9%||3.2%||3.1%||2.7%|
|New fiscal targets||2018||2019||2020||2021|
|Nominal GDP growth||2.5%||3.1%||3.5%||3.1%|
Source: Continuum Economics
As Multi-Notch Downgrade Risks Recede, Near-Term Supportive Factors May Start to Prevail
With both further rating actions and EU enforcement falling off markets’ radar for a few months, we expect investors to start focusing more on factors that are likely to be supportive for Italian bonds.
Firstly, although Italy’s €37 billion budget plan for next year would translate into a higher deficit by around €22 billion (1.2% of GDP) than in the case of unchanged legislation, Italy’s debt/GDP ratio would likely remain on a downward trajectory. It would decrease by around 4 ppts of GDP by 2021, albeit at a slower pace than the 8.8 ppts to which Italy had previously committed. Furthermore, the amount of extra spending and the resulting budget shortfall are considerably smaller than what markets had feared following the appointment of the anti-establishment populist government—combined fiscal stimulus proposals were estimated to be worth over €100 billion per annum.
Upside risks to the deficit are likely to be limited to tax revenues failing to rise by as much as €8 billion and the government not being able to deliver the full €7 billion in spending cuts it has promised. Part of this is likely to be achieved by removing existing tax reliefs and spending items already budgeted, therefore leaving only limited scope for additional budget shortfalls. As a result, tax revenues are also likely to be less reliant on the optimistic growth assumptions made by the government in its draft budget plan. Furthermore, higher welfare spending is likely to be capped by the number of citizens that actually decide to retire early, despite the related disincentives or to enter into legal employment.
Italy’s average cost of debt also remains historically low at around 2.75% and is set to rise only gradually as yields rise to the long average maturity of Italy’s debt, as around 10% of the outstanding debt is rolled over each year. As a result, despite the recent sharp rise in bond yields, Italy’s funding costs remain very manageable and are likely to rise from 3.5% of GDP in 2018 to 3.6% in 2019. The government has already factored this into its new deficit estimates.
Figure 3: At 320 bps Over Germany’s, 10y Italy (BBB) Trades Closer to Greece (B) Than to Portugal (BBB-)
Source: Bloomberg, Continuum Economics
Risks that Italy may decide to leave the Eurozone have abated significantly, as both key cabinet members and political leaders of the governing coalition parties have renewed their commitment to Italy’s participation in the single currency. Recent polls also suggest Italians widely support EZ membership (around 65% of the population surveyed, higher than the EZ average), while they are less happy with EU institutions.
BTPs Look Undervalued Versus Greek and Portuguese Bonds as Spread-Widening to Bunds Looks Excessive
Against this backdrop, we find the spread of 320 bps currently offered by Italian 10y bonds over German Bunds as excessive when compared to where 10y BTPs traded in June. Also, Italian 10y paper currently yields only 70 bps less than comparable Greek paper (rated B3/B+/BB-) and 160 bps more than 10y Portuguese bonds despite Portugal’s debt being rated one notch below BTPs and, at over 125% of GDP, not too far relative to GDP from that of Italy.
We therefore see any further widening as an opportunity to enter tactical spread-tightening trades, as we expect Italian bonds to recover most of their 90-bp underperformance since Italy’s draft budget was presented in late September. While we expect concerns about Italy’s credit rating to re-emerge in Q1 2019, we think that 10y BTP-Bund spreads could tighten toward the 220-bp area by year-end. This would be supported by Italy’s balanced net issuance outlook until the end of December, large redemptions and coupon flows for over €15 billion due in early November vis-à-vis a usually lighter issuance in the last month of the year. Additionally, there is the possibility of further sizeable debt buybacks given the estimated large availability of cash in the Treasury’s account at the Bank of Italy.
Nevertheless, further widening below this target is likely to be limited by the high level of yield volatility Italian bonds have experienced recently, which has risen to levels unsuitable for typical investors holding IG-rated sovereign bonds in DMs. Indeed, over the long term, this may lead to a further gradual reduction in holdings of Italian debt securities by foreign holders, therefore reducing the investors’ base as the ECB is also set to terminate its purchases of Italian bonds in December while Italian lenders will likely further trim their exposures to the sovereign.