Italy’s lingering budget jitters

O sole mio

It's budget time in Italy. Investors are fretting how much of this populist coalition’s wide ranging (and expensive) agenda is going to make it to policy.

Italian debt securities have re-priced lower over the summer with investors now demanding a higher premium to lend to this Italian government.

For their part, officials have recently been seeking to reassure investors that the budget deficit will likely not violate the EU rules and stay within the EU imposed 3% limit.

Even so, medium term questions remain on how Italy can reduce their large debt pile, now sitting at over 130% of GDP. The most recent elections show that public appetite for the necessary reforms is low and in the meantime, the economy will remain hobbled by a range of chronic structural factors1.

Italian yields diverge
Italian yields diverge

Italian interest rates have diverged from international trends over the summer (figure 1), which as figure 2 shows is primarily driven by credit fears (i.e. a credit risk premium has been priced into the Italian bond market).

Italian yields driven by credit risk
Italian yields driven by credit risk

However, asset prices reflect views and sentiment presently held by investors in aggregate. We also know that investors tend to herd and overshoot in sentiment every so often as emotions may get in the way of rational pricing theories.

Are credit concerns being priced in?

In tactical asset allocation we are constantly asking ourselves whether current asset prices are a fair reflection of the near to medium term prospects as we judge them. As a result we closely assess the developments in the risk premia investors demand for holding particular assets. In bond markets this risk premia (i.e. what is the return an investor would receive if nothing changes), can be calculated based on the current yield curve.

For the main bond markets we see a compensation at this time of about 1% per annum for US Treasuries, 1.7% per annum for UK Gilts and 1.98% for German Bunds.

This compares to Italian BTP’s which currently stand at a 4.3% premium per annum, reflecting a sizeable risk premium in addition to the interest rate risk.

Have the credit worries been sufficiently priced in? Is an investor adequately compensated by a premium in excess of 4%?

An opportunity for the “brave and nimble”

Here we possibly have to consider medium term fair values or equilibrium interest rates. In terms of longer term fundamentals and the structure of the economy, one would expect the trend run-rates for growth and inflation for Italy to be at the lower end, say for example 1% for each. Also an inflation risk premium is plausibly lower in Italy than for Germany. 

Absent of any credit fears, this would suggest a fair-value or equilibrium interest rate that is likely lower than a 10-year yield of 2.9%. The Italian bond market is the fifth largest bond market in the developed world2, and ‘market forces’ may direct the populist coalition as they have before3.

If we fast forward six months from now, and the budget deficit is set within the EU limits of 3% as promised, this suggests an opportunity for the brave and nimble.