Italy may be the eurozone’s third-largest economy, but it’s also regarded as a wobbly outlier, or dismissed as one of the southern debt-laden PIGS – Portugal, Italy, Greece and Spain.
But that label hasn’t stopped yield-starved investors from flocking to Italy’s bond sales this year.
For Italy, it’s been a welcome reprieve. In Autumn last year, bond investors feared the EU might slap Italy with an excessive-deficit procedure and bond markets reacted with heavy selling and spiking yields.
But this year market sentiment towards Italian bonds has shifted.
“Italy forged a compromise with Brussels over its deficit spending last December and markets don’t expect rising interest rates this year given Europe’s waning growth outlook,” said David Zahn, head of European fixed Income at Franklin Templeton.
Zahn added that Italian bonds now offer a sweet spot between too risky and too safe, especially relative to German bunds, which are dipping again into negative yields. However, he warned this shift in sentiment doesn’t mean Italy is in the “free and clear”.
The Italian economy fell into recession at the end of 2018, and the Dutch are demanding Brussels strictly enforce, not fudge, Italy’s spending this spring, he warned.
Italian debt risks
“For investors who are concerned about Italy’s debt, it’s important to know this is an old problem, not a new phenomenon; Italy’s debt averaged 111% of GDP from 1988 through 2018, hitting an all-time high of 132% last year and a “low” of 90% in 1988,” Zahn said.
“We think it’s fair to point out the rate of Italy’s debt growth – an increase of around 30% of GDP over the past decade – is just half that of its peer Spain for the same period (see chart).”
Zahn continued: “Italy’s debt is still undeniably large and merited an explanation from them Italian Treasury last year. They responded by pointing to Italy’s enduring “primary surplus”—this means Italy’s tax revenues exceed programme spending – equally a surplus – but only if you ignore interest paid on outstanding debt.
“Maintaining a structural primary surplus doesn’t absolve Italy’s debt problem, in our opinion. It does, however, point to Italy’s original sin: its unstable political institutions.
“For decades, Italy has had short-lived and volatile governments— 15 prime ministers in 30 years—who added debt and stymied any overhaul of a state bureaucracy typified by infinite red tape and corruption,” he said.
“Italy’s politics were once again front and centre in last year’s clash with Brussels over deficit spending. The left-wing Five Star Movement formed a tenuous alliance with the far-right nationalist Lega to push through increased public spending, but not the taxes to pay for it.”
Italy is likely to remain in the eurozone, Zahn added.
“If Italy doesn’t get its way with Brussels, will it push to exit the eurozone? We don’t think so. Italy’s coalition government doesn’t have enough parliamentary seats to call for a Brexit-like referendum. More importantly, Lega’s core voters are overwhelmingly pro-trade and pro-business. They want lower taxes and a tough stance on immigration, not crashing out of the eurozone,” he said.
“Looking ahead, our biggest concern for Italy is – no surprise – debt. If Italy fails to start reducing its public debt over the next two years, we think it faces a potential ratings downgrade which would likely force some institutional investors to reduce their Italian sovereign exposure.”
A question of Spain
During the eurozone crisis, investors often lumped Spain together with Italy because of their debt and this year the two Southern European countries are again being linked because of the rise of populist politics: a surging tri-party coalition, led by the hard-right Vox party, is drawing parallels with the rapid rise of Italy’s Lega party.
Zahn said that, politics aside, Franklin Templeton sees stronger economic fundamentals for Spain compared to Italy.
“It is true that Spain’s public debt has grown faster than Italy’s since the financial crisis. But it has at least spent some of that money on infrastructure, such as new roads and high-speed rail – necessary building blocks for productive nations.
Spain’s growth of GDP per person has also outstripped Italy’s since 2008. Spanish bonds don’t offer Italy’s yields – Brussels is not threatening Spain with sanctions, for example – but are still compelling relative to German bonds, Zahn said.
“We view Germany’s bonds as being safer than Spain’s – safer even than US Treasuries – but they don’t offer enough returns to meet our requirements. No risk, no return.
“Spain has received warnings about its deficits in the past from Brussels, and even a symbolic “zero” sanction meant to encourage better fiscal behaviour without fanning anti-EU sentiments. Brussels is currently taking a more lenient approach, however, with France.
“As the Yellow Vest protests spiralled into damaging riots across France, the government announced new spending measures to mollify protestors. Even though this spending pushed France’s deficit past EU limits, Brussels conspicuously chose not to issue a warning,” Zahn said.
“We don’t think France’s economic fundamentals merit this indulgence from Brussels, nor from bond markets for that matter.”
“In a union dominated by its productive northern economies, German and French bonds simply don’t offer the return profiles we’re looking for. For the time being, we’re embracing the income opportunities that Italian and Spanish bonds offer, with caution. From our perspective, these bonds are outshining their northern neighbours.”