By Mike Bird
The prospective antiestablishment government of Italy has
shocked markets, with bond yields jumping higher on the potential
for anti-euro policy positions and a burst of new government
spending.
That puts investors who have funneled gobs of money betting on
Italy's economic recovery in a difficult position: stick around for
a volatile ride or turn tail.
"There's a wall of money that's likely to step back from Italy,"
said Chris Iggo, chief investment officer of fixed income at AXA
Investment Managers. "A lot of investors have been overweight
Italy, they've been higher yielding, it's not surprising to see
people closing those long positions."
In the past week investors have driven Italy's 10-year
government bond yields up by around half a percentage point
compared with their German peers to 1.75 percentage points, the
fastest increase in around five years, leaving them wondering how
far conditions can deteriorate.
Until recently Italy was regarded as a market darling. Investors
have been particularly enamored with Italy's banks, which are seen
as having turned the corner on resolving a monumental pile of bad
loans. Italy's broader stock market had beat both the rest of
Europe and the U.S., and government bond yields were falling
against those of other countries.
Then an election in March left Italian political mainstream
parties lagging, and gave two antiestablishment political parties
-- Lega and the 5 Star Movement -- with a narrow parliamentary
majority. A leaked draft agreement between the two parties included
proposed debt write-offs and huge spending commitments that would
risk the country's membership of the euro.
That helped spark the bond sell off in recent days. Despite
that, Italian bond yields remain low compared with their historic
highs. As recently as the tumult leading up to the French
presidential election in March 2017, spreads between German and
Italian 10-year yields passed 2 percentage points. In the midst of
Europe's sovereign debt crisis, they passed 5 percentage
points.
Even as some investors have unloaded government bonds and bank
shares, others are sticking to their guns and staying invested,
citing improved economic and financial fundamentals.
Marc Stacey, a credit fund manager at BlueBay Asset Management
said it would be a mistake to turn bearish on the Italian banks,
noting their improved profitability and asset quality. All the
same, Mr. Stacey added, he has recently bought credit default swaps
to hedge against the risk of a further deterioration.
The FTSE Italy Banks index is still up 2% for the year, but was
up 16% as recently as late April, tumbling as government bond
yields have risen.
"We continue to hold UniCredit which we believe is an
attractively valued bank experiencing a return to growth after
restructuring," said Lewis Grant, equity portfolio manager at
Hermès Investment Management, who added that it was too early to
say whether recent volatility reflected sentiment alone or a shift
in fundamentals.
A major issue is whether the incoming government will sully
Italy's relations with European institutions. Italy's government
bonds are still heavily dependent on support from the European
Central Bank's bond purchases, and the country's wider financial
system is more closely linked to government debt markets than in
much of the rest of Europe.
Sentiment toward those government bonds has turned so quickly
that liquidity for some Italian debt in the interbank market
disappeared briefly on Monday, according to a government bond
trader working for an Italian bank.
A sale of around EUR250 million ($295 million) to EUR300 million
in Italian government bonds --a large but not unusual quantity --
left prices for the majority of bonds with longer maturities
unavailable for between five and 10 minutes. An inability to find
price quotes was a common phenomenon in 2011 and 2012, according to
the trader, but had ceased to happen in recent years.
The ECB's rules allow it to buy government bonds as long as the
country has an investment-grade credit rating. Italy's credit
ratings with Standard & Poor's, Moody's and Fitch are each two
grades above junk territory.
"With the ratings firms, it would be a big political call for
them to junk Italy but it's a real risk. That would have knock-on
implications for Italian banks and corporates," said AXA Investment
Management's Mr. Iggo.
ECB purchases have made Italian government bonds less dependent
on international capital, according to Cedric Gemehl, Europe
analyst at Gavekal Research. Nonresidents now hold 32% of Italy's
government debt, close to the lowest levels since the financial
crisis began in 2008.
For the country's financial firms, the health of the Italian
government bond market is paramount. Such debt made up around 8.5%
of the assets held by the country's banks in February, compared
with 3.5% for the euro area more generally.
"A debt restructuring would just kill the Italian banks. Even a
10% haircut on the bonds would cripple the system," said Dhaval
Joshi, chief European investment strategist at BCA Research.
Isabelle Vic-Philippe, head of euro rates and inflation at
Amundi Asset Management, said: "The link between banks and the
sovereign is weaker than it used to be, but it's still there."
The size of the Italian financial system is also a concern to
investors.
"It's not like Portugal or Greece," Ms. Vic-Philippe said.
"Italy is a big country, and it's too big a risk."
She also said that the firm had closed its long position on
Italian government bonds after the country's election, because of
the perceived complacency of the market, but now has a small
tactical long position on the market.
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
May 22, 2018 13:11 ET (17:11 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.