Italy and Europe’s Debt Markets: Is there an Entry Point Soon?
Italian assets continued to take a hit as we went to press in May, with the government’s two-year note – the debt instrument most sensitive to changes in political risk – being slammed the hardest, rising to its highest level in four years, breaking through 2.7% for the first time since 2013. The longer-dated yield on the Italian 10-year note reached 3.38%, up about 70 basis points from the previous close.
Italian equities also got knocked about, with the benchmark index, the FTSE MIB, tumbling some 3% before staging a moderate comeback. Unsurprisingly, the euro dropped below the $1.16 level against the US dollar for the first time since November of 2017 to $1.158. Commodity prices are set to rebound after falling off the previous week. Both the greenback and the yen firmed up.
The sell offs came after Italy’s president, Sergio Mattarella, thwarted an attempt by the Five Star Movement (M5S) and League to form a coalition government by blocking the nomination of the new finance chief, Paolo Savona, a known Eurosceptic. The president has the power to approve or block cabinet appointments, and the fear was that Savona’s belief that Italy should have a ‘Plan B” to exit the euro was determinative. Quitting the currency union causes market jitters as holders of Italian assets fear that they might be re-denominated in a cheaper local currency (the return of the lira) or, in the case of bonds, defaulted on.
The president will now attempt to form a ‘technocratic’ government (a term many of us heard often in the late 1990s, deigned to bolster investor confidence in a new government), led by Carlo Cottarelli, a former IMF official. However, the new regime is unlikely to survive a confidence vote in parliament, meaning that Italians could return to the polls in late summer or early fall, with the prospect that the two parties will be given an even stronger electoral mandate to exit the euro.
Fortunately, PRS saw much of this coming last April, noting that there was a ‘growing risk of repeat elections’ following the March general election, with both the M5S and League received additional voter support.
We also offered our clients this cautionary note: ‘The failure to form a permanent government is not a complete disaster, as Spain has shown when it also took longer-than-usual to go through the motions, and similarly operated in a caretaker capacity for an extended period. However, Italy is in a rather more difficult predicament, with a weaker economy, a creaking banking sector and incomplete structural reforms – contributing to the widening spread on their respective benchmark government bond yields.’
We also mentioned that ‘…even with the new government approved there is a higher risk attached to policymaking in view of the ideological direction pursued by M5S and League, not least the Euroscepticism which may create momentum for holding a referendum on Italy’s participation in the euro zone that many have blamed for Italy’s plight in recent decades involving its inability to produce strong and sustainable growth, producing high unemployment, and contributing to the debt burden. The rejection of fiscal orthodoxy and the combined effects of the M5S plan to introduce a universal income for the unemployed, with League sticking to its aim of a 15% flat tax, would almost certainly create a hole in the budget finances at a time when more careful Treasury management is required.’
Looking ahead over the short-term, we still hold this view: PRS has little confidence that M5S and League will work for long with the new prime minister; fresh elections could be held after the summer recess. In the meantime, the markets will calm a tad – sell-offs are always overdone – but the prospect of a spendthrift and Eurosceptic government will keep anxiety levels high. This sort of pressure – in the worst-case scenario – could disrupt Italy’s ability to tap the capital markets in an efficient manner; the focus on debt and dwindling growth may prompt another asset sell-off.
However, as our data show – and as discussions with some of institutional investor clients over the weekend suggests – soon it might be an opportune time to establish some entry points in Europe’s debt markets, particularly as it does not appear the European Central Bank’s purchase program might now be delayed for the time being.
Turning to ICRG’s ratings this month, confidence indicators throughout most of Europe are either dipping or plateauing, and Argentina’s risk profile has suffered given the government’s decision to seek precautionary financing from the IMF. The Fund is super unpopular in the country, and with this in mind President Macri’s path to re-election next year just became a tad more complicated.
In Gabon, elections have been delayed and a new interim government has been installed following the decision by the country’s Constitutional Court to dissolve parliament. The new regime will do little to help foster a healthy and unified opposition, further undermining Gabon’s democratic credentials.
Guyana also saw its risk profile deteriorate slightly as we see and hear efforts by the authorities to stifle political dissent. This has already hurt popularity levels of the Granger government. On the bright side, while growth is slowing, oil production and slightly higher commodity prices going forward could help improve the government’s coffers and address such issues as corruption in an effort to improve the business climate.
Finally, in Nicaragua, political protests continue, and the UN has condemned the government’s use of death squads to silence critics of the Ortega regime. The protestors are urging Ortega to resign, amidst dwindling popular support. Tellingly, the backing of the Church and the private sector is eroding, and there are now cracks in the coherence of the military. Not quite what Ortega and his supporters want to see happen.
ICRG’s political risk score for Nicaragua has been falling since the beginning of the year and is now in the “high risk’ category.
Meanwhile, clients and friends should note that a new book on political risk is slated for a December release. This collection, co-authored by Peter Marber (www.petermarber.com) and Christopher McKee (www.christophermckee.net) will cover topics as diverse as technology and future unknowns, artificial intelligence, new forms of military warfare, foreign direct investment in high-risk environments, as well as concepts and approaches and rating systems. Given its depth and the stature of those writing the various chapters, the book promises to be a landmark contribution to the field.
We are also happy to announce and PRS and Gavin Serkin, the Managing Editor at Frontier Funds Media and Intelligence and Exotix Capital, will be joining forces next month in an effort to showcase much of our data and analysis. We have known Gavin for some time, and are impressed with his credentials, having been formerly Bloomberg’s European investing reporter, and the editor of Portfolio International, along with the news editor for a series of weekly newspapers in London and Southeast London.
Gavin is also the author of a very informative and enjoyable book, titled: Frontier: Exploring the Top Ten Emerging Markets of Tomorrow (Bloomberg Financial Press, 2015).
As always, ICRG’s data figures heavily in the research of the IMF. Recently, the Fund looked at the behavior of emerging market equities and bonds and asked (inter alia): Which are more sensitive to global factors? Which chase returns? Which are more volatile? The results are significant for asset selection and portfolio balancing. (https://lnkd.in/eqzGTTd)