Political uncertainty weighs on Italy

Italy’s struggle to form a government and the threat of a new election have caused bond spreads to widen, signaling market concerns. Despite Italian bonds recovering, volatility is running high and investors need to ask whether there will be a contagion impact across Europe and the globe.

Below, Legg Mason’s affiliates share their views on the current situation in Italy.

Valuations are starting to look interesting
Jack McIntyre, Global fixed income portfolio manager, Legg Mason affiliate Brandywine Global

“Italy has too much debt and not enough economic growth—a toxic combination that creates a gravitational pull toward market stress. Compounding the problem is the fact that there has been no real progress on fiscal unity in the eurozone. Markets are demanding a political risk premium in order to own Italian assets.

Meanwhile, there is less of an inflation-risk premium to own U.S. Treasuries. Yields on two-year Italian sovereign bonds are spiking more than during the European crisis of 2011-2012. It took Draghi’s emphatic “whatever it takes” speech in defence of the euro in mid-2012 to turn things around then. Now, the ECB is skewed toward being less accommodative with its tapering of asset purchases. In contrast, the U.S. economy is doing well versus slowing growth in Europe. However, we do not think Italy derails the positive growth outlook for the global economy.

We would be wary of reinitiating exposure to Italian government bonds (BTPs) if government debt swells, either as interest expenses or spending increase, or a combination of both. However, we believe that questions regarding debt sustainability do not warrant the same level of caution as 2012—the local and regional economies are performing better and rates remain low on a relative basis.

While we do not have plans to buy Italian government bonds in the short term, valuations are starting to look interesting; however, significant information risk remains.

Markets sold off too sharply and too quickly and we are assessing whether this is an opportunity to re-enter the Italian bond market.

At nearly 90% of the market, large institutional investors mainly own Italian BTPs, which we believe bodes well for market liquidity in the longer term. These buyers tend to hold onto the bonds until maturity; the average maturity on Italian debt is approximately eight years, thereby reducing rollover risk.

Domestic Italian banks hold about 30% of outstanding BTPs on their balance sheet, and French and Spanish banks are also notable bond holders, though foreign banks hold around 10% of issuance. Italian debt is over 100% of tier 1 capital from some banks. However, foreign bank ownership of BTPs has declined by 50% over the last decade. The European Central Bank (ECB) owns approximately 20% of BTP issuance, or €341B worth of Italian bonds, with room to purchase more if market conditions continue to deteriorate. The ECB could increase its monthly purchases by €3.5B if necessary, providing a cushion for liquidity.”

We need the spirit of Horatius
Michael Browne, European Long/Short Portfolio Manager, Legg Mason affiliate Martin Currie

“After the flight to German bunds, the selloff in Italian BTPs, the 3% fall in equities, is it safe to go back in the water? We would argue no: The need to address the lack of prosperity in Italy will not disappear and thus the remedies will sit outside of the EU’s economic rule book.

The risk premium level for Europe is rising and whilst Europe is fair value, it is not cheap. We sold it when it was expensive and we believe this will provide the opportunity to buy it back cheap. The currency may well weaken further which whilst good news in the longer term will stoke inflation, putting the ECB under more pressure to raise rates.

We are not forecasting the end of the recovery in Europe, we think we are in the mid cycle, which can last several years. We are looking at the European economy cruising at around 1.5% to 2% with 1 to 2% inflation. This is normally a period when bonds underperform as rates rise and equities achieve slow gains. Italy could be a positive: The evidence from the USA is not that fiscal laxity is a problem, it is a positive.

But in Italy the stakes are much, much higher: if fiscal expansion doesn’t work what then? ECB bail out of Italian debt and Italian banks? Transfer payments from other EU members, especially Germany to bail out Italy? The imposition of IMF/EU program forcing deep internal cuts, a radical labour market and corporate reform. Would that be the point that Italy leaves the Euro and maybe even the EU as this is politically impossible?

The economic shock of any of those would be considerable but would be easier to manage while the cycle was positive for the rest, rather than when Europe and maybe the world is in recession. Logic says we should encourage the Italians to go for it: it could work.

But European and Italian politics is anything but decisive. Muddle through and hope will leave Europe very exposed in the next recession. We need the spirit of Horatius, to take a risk and succeed…. or at least get a lucky escape like Horatius did 2,500 years ago.”

Italian banks – time to sell or buy – part 1 Michael Testorf, Global equity portfolio manager, Legg Mason affiliate ClearBridge Investments

“We were initially attracted to Italian and other European banks as structural growth stories trading at discounted valuations that would benefit from rising rates and a better political backdrop. Recently we reduced our Italian banking exposure. The main reason is the economy in Italy, which was finally on good footing, is starting to show weakness according to early indicators. The uncertainty will have an impact on GDP growth for the second quarter.

A GDP slowdown could also lead to less loan growth in Italy. A worst-case scenario — Italy leaving the euro — would create a deposit flight from Italy to Germany, as happened in Greece. Deposits are the blood line of retail banks and this flight would damage the Italian banking system.

Political unrest in Italy could cause the ECB to delay its rate tightening plans, creating a less conducive environment for most European financials and calling into question our bullish view of bank earnings growth

Italy completed an auction of 5- and 10-year bonds this week, but the pricing suggests that much is still to be resolved in the EU’s third-largest economy. We prefer to await more clarity before returning to Italian financials in our growth strategies.”

Italian banks – time to sell or buy – part 2
Annabel Rudebeck, Head of non-US Credit, Legg Mason affiliate Western Asset Management

“Italy’s banking system is much less risky now given the cleanup of the weakest banks and de-risking forced by the regulators since the global financial crisis. Italy’s problem loans remain high, but have dropped dramatically. The two largest banks, Intesa and UniCredit have much less credit risk than the Italian banking system overall.

We maintain a cautious view on Italian banks at Western Asset. From a broader perspective, name-by-name disclosure on “Italy exposure” is patchy but the Financial Stability report from the Bank of Italy shows significantly reduced levels of international wholesale funding.”

Will the ECB continue to buy Italian debt?
Jack McIntyre, Global fixed income portfolio manager, Legg Mason affiliate Brandywine Global

“Governance in Italy will continue to highlight the fraught relationship that many member countries have with the European Union (EU), and also what role Germany will play within the bloc. The ECB was on the precipice of policy normalization prior to the significant move in Italian yields. Now, we will have to see whether the central bank will continue to buy Italian debt or leave the country to its own devices.

Over the last year, Germany and Chancellor Angela Merkel have made progress in reforming the country’s image of the hardline enforcer of austerity, most notably in its détente with France. Only time will tell whether the Germans will take a more relaxed, laissez faire approach with Italy, as they have done with President Emmanuel Macron and France.”

Legg Mason June 2018



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