Wed, 06/03/2020 – 05:00
It’s been a wild ride in May for Italian government bonds, so-called Buoni del Tesoro Poliannuali (BTPs). The yield spread of 10-year BTPs over 10yr German Bunds first rose to c. 250 basis points (bps) after the German Constitutional Court had ruled that the ECB’s Public Sector Purchase Programme (PSPP) was partly unconstitutional. Subsequently, the Italian risk premium collapsed to c. 190 bps when the COVID-19 situation started easing and details around the proposed EU recovery fund were unveiled. European bond investors are scratching their heads about the direction of travel for BTPs, going forward. In my view, we have to take into account three key aspect—the Good, the Bad and the Ugly.
The Good: Next Generation EU
Clearly, the European Commission’s plan to launch ‘Next Generation EU’, a €750 billion EU recovery instrument, is excellent news for the European periphery and especially Italy. The proposal combines joint borrowing at the European Commission level with the provision of grants and loans to the regions and countries most affected by COVID-19. The European Commission went above and beyond what many political observers had previously considered possible by clearly prioritising grants over repayable loans. In fact, two thirds of Next Generation EU funds, i.e., €500 billion, would be distributed in the form of grants. Italy alone would receive more than €80 billion in Next Generation EU grants, more than any other country.
Beyond immediate crisis relief, Next Generation EU could have more far-reaching implications. Many a commentator enthusiastically referred to the Merkel-Macron plan for a grant-focused EU rescue fund, on which Next Generation EU is based, Europe’s seminal ‘Hamilton moment’. If this is the case and the EU really moves towards fiscal integration, we should expect yield dispersion in the Euro area to drop sharply. In this scenario, BTPs are very likely to perform particularly well. With the exception of Greek debt, Italian BTPs are currently trading at a higher risk premium over Bunds than any other Euro area government bonds—more than 90 bps wider than Spanish bonds at the 10-year point, for example—thus offering a greater potential for spread compression.
In my view, there is considerable downside risk to the BTP compression trade, though. So far, Next Generation EU is just a proposal, albeit a bold one, which still requires support from EU member states. It is entirely within the realms of possibility that the plan is watered down, delayed or scaled back in the process. In fact, Austria, the Netherlands, Sweden and Denmark—the so-called ‘frugal four’—have already presented a counter-proposal, based on repayable loans rather than grants. Chancellor Merkel, one of the architects of the proposal, is also facing headwinds at home, not least within her own party. One of the key points of criticism is that allowing the European Commission to borrow €750 billion on behalf of the EU to fund Next Generation EU could be construed as European debt mutualisation through the back door.
The Bad: Italy’s economic outlook and debt burden
Even if Next Generation EU is implemented as planned, it could turn out to be merely a one-off measure rather than a Hamiltonian watershed moment ushering in a new era. If in the end European fiscal integration proves elusive, Italy’s Next Generation EU boost might be short-lived and markets are likely to shift their focus rather swiftly back to the country’s fundamentals, which do not give occasion to overwhelming optimism. Even before COVID-19 struck, economic growth in Italy was anaemic. The economy already contracted in the final quarter of 2019 by 0.2%. The latest quarter-on-quarter GDP print (-5.3% in Q1 2020) is concerning and distinctly weaker than for the Euro area as a whole (-3.8%). According to a recent Bloomberg survey amongst 32 economists, the Italian economy is expected to shrink by 10.3% this year.
And while 2020 is going to be a highly challenging year for most economies, what makes the situation particularly precarious for Italy is the country’s high debt burden. According to Eurostat, Italy’s government debt-to-GDP ratio is close to 135%, which is more than 50 percentage points higher than the Euro area average (84.2%). Taking into account the Italian government’s recently announced €55 billion stimulus package, in combination with the shrinking GDP base, the EU Commission expects Italy’s public debt to jump to nearly 160% of GDP this year, a whopping 100 percentage points above the maximum debt level stipulated in the Maastricht Treaty.
So far, the prospect of Italy’s government debt rising to eye-watering levels has not spooked investors. One of the key factors is clearly the ECB’s ultra-accommodative monetary policy stance. The €750 billion Pandemic Emergency Purchase Programme (PEPP) in particular carries weight. Unlike the PSPP, the PEPP gives the ECB a fair amount of flexibility to tilt purchases of public sector securities away from the capital key of the national central banks. When push comes to shove, the ECB could ramp up BTP purchases, thus providing a backstop and calming markets, at least temporarily. Over the long-term, however, I don’t think central bank support alone is going to be a panacea to Italian indebtedness. Unless a credible path towards pan-European fiscal integration emerges, bond markets are likely to call into question the sustainability of Italy’s debt burden at some point.
And the Ugly: Italian politics
One important risk factor around BTPs, which is currently neither debated much nor priced in, is politics. Granted, the situation seems less fragile now than at the beginning of the year, when Eurosceptic opposition party Lega was above 30% in opinion polls. Since then, Lega support has dropped by around 5 percentage points, while Italy’s government coalition has closed ranks and prime minister Conte’s approval ratings have soared.
Growing support for the current leadership in a moment of crisis isn’t unusual, of course. The question is, how long will it last? Chances are that as soon as the nature of the crisis shifts from public health to economic depression, Lega and other opposition parties will gather steam again. Especially in case pan-European crisis responses falls short of expectations, anti-EU political forces would have plenty of verbal ammunition to pull in votes. A number of regional elections, taking place later this year, will be an important litmus test. Investors only have to look back two years in order to remind themselves how sensitive BTP valuations are to political risk in Italy. In May 2018, BTP yields jumped from 1.75% above 3% in a matter of weeks when a coalition government involving Lega took shape and anti-EU rhetoric was dialled up.
Undoubtedly, BTPs have a lot going for them right now. The Next Generation EU proposal has evidently boosted investor confidence in the European periphery. And many market participants expect that the ECB is going to announce later this week an expansion of PEPP purchase volumes by €500 billion, which would be another tailwind for BTP valuations. Hence, it is entirely possible that BTPs spreads continue to compress, at least in the short run. However, medium to long-term I remain very cautious. Without ever deepening pan-European fiscal integration, which may or may not happen, BTPs are very likely to come under considerable pressure again due to Italy’s economic malaise, its towering debt burden and political fragility. In my view, at a spread of c. 190 bps over Bunds investors might not get adequately compensated for the lingering risks.
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Author: Tyler Durden