“Possible downgrade”
The current jitters are a political creation needing a political solution. For now, as we wrote in May and June, the issue isn’t Italy’s debt solvency, which remains sustainable thanks in part to its current account surplus and the continued low interest rates.
That solvency calculation would change if the Italian government pushed through a 2019 budget that undermines the sustainability of its debt. In such a situation, credit spreads would widen further with a possibility of rating downgrades. This would in turn affect financing costs, raising the likelihood of a government collapse and triggering another election, an outcome that neither coalition partner wants to provoke.
Fitch ratings agency held its ‘BBB’ credit rating for Italy unchanged on 3 September and cut its outlook to ‘negative’ citing the “new and untested nature” of the government. Moody’s has postponed its review of the country’s sovereign rating, marked as a “possible downgrade,” until the budget’s publication. A downgrade by all three major ratings agencies to below investment grade would force institutional investors to divest and the country’s government debt would no longer qualify for some indexes.
On 30 August, the yield on the Italian 10-year sovereign bond reached 3.21% while the spread between Italian 10-year paper and German sovereign bonds reached 284 basis points, the widest since July 2013.
Impact on Italy’s banks
The widening spreads have impacted capital held by Italy’s banks, and are raising their funding costs. This spread widening also increases volatility in stock movements. To date, we have not seen an impact on the non-performing loan market (NPL) and sales continue at reasonable prices. Were this to change it would undermine smaller banks’ capital as well as their NPL-reduction strategies.
Adjusting exposure
Investors should closely watch Italy’s budget build up, including the announcements and reactions from the European Commission that we will begin to see later this month. This will help us to anticipate any contagion from Italy’s new economic agenda into the wider Eurozone. As for European assets, we have adjusted our exposure to European equities to neutral as the region has become relatively less attractive. In addition to the political uncertainties surrounding Italy’s relationship with the EU, fears surrounding trade spats with the US could slow Europe’s momentum. There is also a risk that the cycle in Europe comes to a premature end if rising US interest rates trigger a fall in the markets.
Important information
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