Concerns regarding the Italian 2019 Budget hurt domestic assets, with pressures spreading to European assets
In our previous Global Markets Roundup bulletin, we highlighted the increased negative correlation of BTP Government bond spreads with Italian bank equities (see graph 2 page 3). Unsurprisingly, the decision by the Italian Government to announce a headline budget deficit target significantly higher than consensus and European Commission expectations led Italian Government bond spreads higher across the curve, while Italian equities suffered significant losses.
Specifically, 10-year BTP/Bund spreads widened by 32 bps to 268 bps, with FTSE/MIB declining by 3.7% (-5.2% ytd) and Italian banks losing 7.3% on Friday (-15.2% ytd). Note that Italian banks hold circa €375bn in BTPs (or 93% of their capital). A sustained decline of Italian Government bond prices could erode Italian banks’ capital (CET1 of 13.2% as of Q1:2018 according to EBA data).
European assets came under pressure, following the events in Italy, with the Eurostoxx index declining by 1.3% (-1.9% ytd) and the EUR down by 0.3% at $1.16 against the USD on Friday. Periphery bonds were broadly unaffected, with Portuguese and Spanish yields remaining flat at 1.50% and 1.88%, respectively. However, on Monday/Tuesday, Italian 10-Year Yield was up cumulatively by 26 bps to 3.40% (BTP/Bund spreads at 298 bps) as concerns regarding Italy intensified, with Portuguese and Spanish bond yields up by circa 5 bps.
The envisioned fiscal loosening is significant as the Italian Government foresees a headline budget deficit of -2.4% of GDP each year until 2021, instead of -0.8% (2019), 0.0% (2020) and +0.2% (2021) in the 2018 April Stability Programme. While details have not yet been released, macroeconomic assumptions regarding nominal GDP growth (+3.2% for 2019, +3.0% for 2020 and +2.7% for 2021 in the 2018 April Stability Programme) are expected to be revised up significantly, in order to not put at risk the goal of reducing the public debt, which currently lies at 131% of GDP.
Note that Italian growth has already slowed in H1:2018, with real GDP at +1.1% saar from +1.9% saar in H1:2017, while leading economic indicators (Ita-coin: Bank of Italy) suggest that real GDP growth could stall in Q3:2018. Looking forward, the Italian Government now has to submit the Draft Budget by October 15th and the European Commission will respond by end-November. It is important to note that rating agencies will issue their assessments over the coming weeks, with Italy currently circa two notches above the Speculative Grade threshold (see graph below). The risk of rating downgrades has likely increased following the 2019 Budget deficit forecasts, suggesting that Italian assets will remain under pressure.
On the other side of the Atlantic, as expected, the Fed raised the federal funds rate target by 25 bps, to 2.0% - 2.25%, and maintained broadly unchanged its interest rate forecasts of 5 hikes (of 25 bps) to 3.25%-3.50% by end-2020 (see Economics). The Fed downplayed the removal of the description of the policy stance as “accommodative” from the post-meeting statement. It would require 3-4 rate hikes before Fed policy enters restrictive territory.
We have updated our quarterly Asset Dashboard (page 3). Global equity markets posted strong gains led by the US and Japan, while trade tensions hurt emerging markets across the board (Equities, corporate Bonds and FX). Government bond yields in core markets rose by 10 bps to 30 bps due to strong growth, increasing inflation and monetary policy normalization.