Investment Research Italy under pressure but we expect the spread to core EU and the periphery to stabilise Jens Peter Sørensen Chief Analyst +45 45 12 85 17 jenssr@danskebank.dk 22 May 2018 www.danskebank.com/ci Important disclosures and certifications are contained from page 8 of this report.
The vicious circle for Italy we are still far from the scenario where Italian banks lose access to the ECB Fiscal expansion by the new Italian government We never got to this stage back in 2011-12, when 10Y Italy was > 7% Loss of access to ECB funding for Italian banks Warning by the EU and EU commission of the debt and deficit Unsustainable public sector deficit downgrade Junk rating The Italian government ignores the EU and market pressure Source. Danske Bank Significant increase in the funding cost of the Italian government Downgrade by the rating agencies 2
Significant pressure on Italian government bonds The proposed fiscal easing by the new Italian coalition government and a Prime Minister with limited political experience have put significant pressure on Italian government bonds. Furthermore, comments that the new coalition government will not bow to market pressure have added to the turmoil. Finally, comments from the French Finance Minister, as well as Fitch, that Italy should stick to its budget commitment are also putting pressure on Italian government bonds. The EU/EU commission will not accept an unfunded fiscal easing by Italy, which would violate the Maastricht criteria. We are still very far from a downgrade by the rating agencies and in our view it is most unlikely that all four ratings agencies would downgrade Italy to junk status (see the rating outlook on page 3). Furthermore, the Italian investor base has a strong home bias as shown on page 4. We currently have a long position in the 5Y Italy versus 2Y Germany. This has underperformed significantly since last week. We keep the trade on even though the performance has been very negative since early last week. The 10Y yield spread France vs Germany and Italy vs Germany 100 90 80 70 60 50 40 30 20 bp 10Y France versus Germany (l.h.a.) 10Y Italy versus Germany (r.h.a.) 10 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Source. Danske Bank 235 215 195 175 155 135 115 95 75 3
Rating outlook very negative comments from Fitch yesterday Italy Moody's S&P Fitch Rating Baa2 BBB BBB Outlook Negative Stable Stable Potential rating decision 07 September 2018 06 October 2018 31 August 2018 Requirement for downgrade The rating would be downgraded if policies enacted or anticipated proved insufficient to firmly place the public debt ratio on a sustainable, downward trajectory in the coming years. A failure to articulate and present a credible structural reform agenda which Moody's concludes will enhance economic resiliency by strengthening growth would also put downward pressure on the rating. We could lower our ratings on Italy if its economic growth slumps, bringing its performance once again to well below that of sovereigns at similar levels of development. If its external performance deteriorates, for example due to the current account balance slipping into negative territory, this could also weigh on the ratings. Ratings pressure could also build if budgetary consolidation falters, especially if the new government abandons its sustained fiscal consolidation path or reverses past structural reforms with an adverse impact on the country's economic prospects and its budgetary position. - Political developments negatively affecting economic and fiscal policies and/or outturns; - A rise in gross general government debt/gdp; and - Adverse developments in the banking sector increasing risks to the real economy or public finances. Source. Moody s, Standard & Poor s, Fitch In the table above, we list the requirements for a downgrade. Looking at the comments from Fitch yesterday and the requirements stated above, we believe it is likely the fiscal policy presented by the new coalition government will change the outlook from stable to negative in the short term. Yesterday, Fitch warned about fiscal loosening and potential damage to confidence but also stated that this depends on how the new government implements its programme. Hence, we are still far from a downgrade in the short term and very very far from Italy being downgraded to junk by all four rating agencies, especially as Italy maintained its investment grade rating throughout the entire EU debt crisis, where 10Y Italy was trading above 7%. See the full comment from Fitch here new Italian government policy would increase fiscal risks. 4
Italian banks have reduced their exposure to the Italian government bonds The ownership structure of Italian government debt is relatively diversified versus what we see in the peripheral countries, where foreign ownership was well above 50% in some countries before the EU debt crisis in 2011-12. Currently, foreigners own some 33% of the debt, while Italian banks have scaled down their holdings of Italian government debt. The big buyer has been the ECB, which has scaled up given the QE. During the debt crisis in 2011 and 2012, when foreign investors sold BTPS, it was mainly the domestic MFIs (banks, etc.) that scaled up on Italian government bonds. Hence, if there was another round of sell-offs, we believe the domestic banks could be buyers again. Holders of Italian government debt, % of outstanding amount 45 40 35 30 25 20 15 10 5 0 08 09 10 11 12 13 14 15 16 17 18 The Italian central bank Italian banks and other financial institutions Life insurance, pension funds etc. Foreign investors Other domestic investor Source. Bank of Italy 5
Spillover effects to the other peripheral countries modest pressure on Spain and Portugal but significant pressure on Greece There has been some contagion towards the other peripheral markets but relative to the movement we have seen in the Italian market, it has been rather limited as shown on the chart on the right. Given that this is mainly uncertainty on Italy relative to the rest of EU, the potential spill-over effect should be limited, as the EU and EU commission have previously shown strong commitment to the rest of the EU countries that follow the Maastricht criteria. If the problems in Italy were to escalate, the spread between Italy and the peripheral countries would widen. The country that is currently at most risk is Greece, where the bailout programme ends on 20 August. The pressure on Greek debt has been high and the new 7Y benchmark that launched back in February with a spread of 311bp to Germany lost significantly as hedged funds took more than 30% of the deal and the spread moved above 380bp. Here the spread had moved back to 330bp by the end of April. However, the turmoil in Italy put pressure on Greece and the spread widened to 385bp, before stabilising at 365bp today. bp 10Y Spain versus Germany 10Y Portugal versus Germany 10Y Italy versus Germany 410 360 310 260 210 160 110 60 10 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 Source. Danske Bank 6
Trade recommendation we are currently long 5Y Italy against 2Y Germany We are currently long 5Y Italy versus 2Y Germany. We took the trade on at 126bp in Government Bonds Weekly A strong conviction trade for Q2: 5Y Italy versus 2Y Germany, 6 April, and it is currently trading at 169bp. We still like the trade and keep it but acknowledge the risk of a further short-term widening, as we do expect to enter the 'vicious' circle. Our base case is that the Italian government will conform with EU rules and the current political uncertainty will settle down. Furthermore, we are very far from a downgrade to junk by all four rating agencies and thus Italian banks can step up their purchase of BTPS and fund these through ECB (although with a haircut). Hence, we expect Italy to tighten again, although the timing is tricky given that the new budget will be scrutinised by the EU commission and the rating agencies. However, Italy is not under an excessive deficit procedure (EDP), so it can be difficult for the EU commission to do much and it has to rely on market pressure to curb an excessive fiscal policy by Italy. The hedge trade is to be long the Bund ASW spread as shown by the widening in recent days. bp The EU curve and credit trade : 5Y Italy versus 2Y Germany, bp 350 300 250 200 150 100 50 5Y Italy vs. 2Y Germany 10Y Italy vs. 2Y Germany 0 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 Source. Danske Bank 7
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