Equity markets have fallen while Treasuries and Gilts have rallied, and safe haven currencies such as the Swiss Franc have outperformed. Asset prices in both developed and developing markets have been impacted.
We have been here before – the 2011/12 Eurozone debt crisis illustrated that highly leveraged sovereigns with insufficient growth and ineffective policy tools will eventually face a populist backlash which in turn leads to a contraction in money supply, more commonly known as financial crisis.
In the case of Italy some things have changed since 2011 and some things haven’t. The general election in March was the country’s 19th since the war. The trigger for the recent sell-off was the Italian President’s rejection of Paolo Savona (a Eurosceptic economist) as the government’s finance minister. Regardless who gets appointed, the administration has already shown its willingness to further flout EU fiscal rules. The market reaction has been swift. A reckless Italy is nothing new, but the market has reacted swiftly and repriced aggressively.
We think there are two components to this repricing to consider. Firstly, while the Italian bond market is the third largest in the world, it is also one of the least liquid in times of distress. This is due to the low credit rating of these securities (mid-BBB) as they impose larger capital charges for intermediaries than AA rated Gilts or Treasuries for example. Secondly, the main buyer of Italians bonds is the European Central Bank (ECB) under its asset purchase program. A price and return insensitive buyer such as the ECB will not be spooked by recent spread-widening.
We also note that more than two thirds of outstanding debt is in domestic hands – insurance companies, banks and pension funds. In Japan, a similarly captive domestic buyer base has supported the government bond market for years where the debt burden is over 250% of GDP compared to 130% in Italy. We would expect Italian yields to be driven as much by technical factors as fundamental ones.
As you can see in the chart below, there are three critical issues at stake for the Italian electorate. However, history has taught us that predicting electoral outcomes is a fool’s errand. We have long held the view that until “politics becomes policy” we should not make material changes to client portfolios.
Our focus is on the fundamental growth trajectory for the Euro area as a whole and how ECB policy actions will support or detract from that. We do not manage Italian government bonds. We are neutral on European equities, with our preferred funds either not investing in European banks for structural reasons or with limited geographic exposure.
The knock-on effects of the sell-off in Italy have been more interesting to us. Systemic risk indicators such as the Gold price, High Yield credit spreads and implied volatility are far from flashing red. Yet we have seen non-Italian assets underperform; French bank equities have declined in line with Italian banks; and Japanese stocks have sold-off in line with Europe. A justification for this can only be assumed if the market is correct in repricing global growth and/or liquidity.
We believe it is too early to suggest that events in Italy foretell an “Ital-exit”, but weak growth and high debt are not the best starting point for an investment. With European banking regulation and ECB asset purchases as supports, there is potential for the markets to overstate Italian sovereign risk. In this event, other high beta assets will naturally underperform and this is where we could potentially add risk. Emerging markets and non-Italian banks appear to be the most likely hunting grounds. If the Euro sells off sufficiently, adding to our European equity exposure in aggregate may also make sense.
We will examine market pricing and events as they unfold for further supports for this view. We may have seen this story before but the ending could be very different.