The Daily Update - Zero Return For Sharing In 2 Years Of Italian Risks

In a report today on the public finances of EU members, the European Commission (EC) has warned Italy to tighten fiscal policy by at least 0.2% of GDP or face sanctions. This target is what Rome had promised the EC earlier this month, but obviously the Commission have yet to see enough progress. An EU official commented, ‘Unless Italy specifies its commitments properly, next week will show that they are not compliant with the debt rule.’ Given that Italy ‘should’ be reducing its deficit by 0.5% of GDP and its debt by 3.6% of GDP per annum this warning already accommodates a fair amount of leniency. With the EC forecasting Italy’s public debt rising to troubling all-time-highs of 133.3% of GDP this year it has given until April for Rome to enact the promised, but yet to be detailed, measures. Given that the EC has shown leniency (relative to its stringent austerity policies) to other members such as Greece and Portugal it seems unlikely that Italy will be fined if it does not meet this timeline, but a formal censure in May is certainly possible and would further increase negative sentiment towards a vulnerable Italy.

Additionally the report considers the risks Germany’s trade surplus pose on the EU, on which it forecasts Germany’s current account surplus this year to reach a record 8.7% of GDP. Despite this the report argues that it is ‘not excessive’. It’s hard for the EC to place the blame for current woes on creditors such as Germany despite the clear advantages they have had from sharing in a more competitive euro. Not only this but today the spread between 2 year German Bunds and US Treasuries reached 20 year highs with Bund yields dipping below -0.92% while Treasury yields have kept above 1.22%. And although (as of yesterday) Italian 2 year debt actually offers a positive return of 0.04% we believe Italian government debt across the curve does not offer investors value.

Although Italian public finances are in a much better state than somewhere like Greece (given that it has actually managed to run a primary surplus since entering the Eurozone) and its Net Foreign Liability position has not yet surpassed our 50% of GDP tolerance level, it remains intertwined with the fate of other Eurozone members. As such there are other (unlikely but not impossible) risks foreign investors in Italy may have to consider: such as the possibility of redenomination of debt. Unlike Greece, for example, which has most of its debt issued under English Law, only 2.5% of Italian debt is under foreign law. As such under an Breakup / Italexit scenario Italy could apply Lex Monetae on practically all its bonds. So regardless of whether Italy defaults under such turmoil bondholders could still have to bear any potential FX devaluation of their new lira bonds (which one could estimate to be in the realm of 30% using the cumulated inflation gap between Germany and Italy since the formation of the euro).

There are €1.9tn of Italian Government Bonds in issue, 63% of which is held domestically (mostly by financials, 46%), with 23% held across the Eurozone leaving only 14% in the hands of other international investors. There are a number of potential upsets for this region in the coming months, including French elections, Greek bailout impasse, Italian shortcomings and as the EC report puts it, “excessive macroeconomic imbalances” in France, Italy, Portugal and other EU members. Those outside Italy holding BTPS may consider monitoring the SENTIX Index which measures the sentiment towards a Eurozone break-up and has a very high 0.9 correlation with Italexit concerns; this now stands at 21.3 and is expected to tick up at the end of the month. We monitor such indices also, but from the sidelines, choosing rather to invest in bonds within creditor nations that offer better value and risk adjusted returns. A practically zero yield for sharing in the next 2 years of Italian risks is not what we would consider a value investment.