Despite concerns about slowing global and eurozone growth, low inflation and dovish central bank rhetoric mean investors’ search for yield, which has so far supported ‘peripheral’ eurozone government bonds, continues.
- Spanish government bond market justifiably stable
- Headwinds remain for Italian economy…
- … and Italy’s political scene is not too stable either
Yield spreads between 10-year Italian and German government bonds widened to just below 300bp early in Q1 2019 after preliminary Q4 2018 GDP data (released at the end of January) confirmed that the Italian economy was in a technical recession. However, the 10-year Italian/German spread remained between 235bp and 275bp for the rest of the quarter. Spanish bonds were also well supported, with the spread between 10-year Spanish and German government bonds moving within a relatively narrow range of 95bp to 125bp over the quarter.
Spain – banking sector healthy, fiscal deficit progress
The stability in the Spanish government bond market is justified, in our view. Despite political fragmentation and minimal economic policy implementation over the last three years, growth in Spain has been largely unscathed by the slowdown in the rest of the eurozone. The banking sector is in good shape, with non-performing loan ratios falling back to 2010 levels. The fiscal deficit fell to 2.6% of GDP in 2018, and while this was a little short of the deficit target of 2.2% agreed with the European Commission, Spain had made significant progress in reducing the deficit to below 3% and achieved a close to flat primary balance.
More importantly, none of the political parties, including the nationalist Vox and far-left Podemos, is openly against the EU or the euro. This, and the progress on the fiscal front, makes Spain far less likely in the near term to get into confrontational situations with the EU about its budget. However, the Catalan issue is unresolved. And if the 28 April general elections fail to deliver a majority coalition government, the secessionist parties could gain more influence, halting fiscal consolidation and structural reform plans, and potentially putting Catalan separatism back on investor radars.
Italian economy – meaningful headwinds remain
In Italy, longer-term concerns about its fiscal health and political risks remain. While the European Commission decided against opening an Excessive Deficit Procedure against Italy in December, the Italian budget agreement remains far from ideal. The deficit targets are challenging given the country’s fiscal loosening plans and lack of economic growth. Aggressive fiscal relaxation in the form of universal income for the poor and the reversal of pension reforms were simply delayed and the funding of these programmes is unclear. The reduction in deficit targets for 2020 and 2021 relies heavily on “safeguard clauses”, in which a VAT increase is supposed to kick in automatically if no alternative fiscal measures can be found. The credibility of the current government’s fiscal discipline is low, and the Italian economy continues to face meaningful headwinds.
On the political front, since the coalition government of radical parties Five Star Movement (M5S) and the League was formed in mid-2018, support for M5S has fallen, while the popularity of the League has risen. Since the recent regional elections in central and southern Italy, the League is the dominant force within the centre-right coalition, garnering roughly 32% in the opinion polls versus 10% for Forza Italia.
Coalition ill at ease
National level differences in the M5S and League stances on these issues have led to a rise in tensions between the two governing parties:
- the high-speed rail link between Turin and Lyon
- devolution of fiscal powers from the centre to the north
- the tactics on migration policy
- joining China’s Belt and Road Initiative.
Given the League’s rise in popularity and its increased friction with M5S, there has been speculation that it can be only a matter of time before the League’s Matteo Salvini will want to break up the coalition, call fresh elections, and secure a clear mandate to pursue the party’s agenda.
In coming months, we see little appetite for a snap election. Such a move at this stage would mean asking the people to vote more or less at the same time as when the European Parliamentary elections take place. The two voting systems are quite different, requiring different coalitions, and the divergent expression of preferences would likely confuse voters and potentially taint the results of one or both elections. A summer election also looks unlikely as traditionally Italy has not held national elections after June.
Political risks will likely retake centre stage in the second half of 2019, particularly if Salvini does well in the European elections and sees it as evidence of his electoral advantage. In such a scenario, the League would likely become the senior partner in a government reshuffle or in a new centre-right coalition government. Market participants will likely perceive such an outcome as market-friendly, expecting that some of the expensive M5S fiscal agenda can then be dropped, and a new coalition would represent a return to political normality.
However, investors should remember that the anti-euro, anti-EU rhetoric over the last couple of years actually came from Salvini’s party. And regardless of who is in charge of the government, the budget discussion for 2020, which will also take place in the second half of this year, will again likely be challenging given Italy’s current fiscal health and the lack of progress on structural reforms.
Exhibit 1: Italian election polls
Source: Poll of Polls, April 2019
This is an extract from the Q1 2019 Inflation-Linked Bonds Outlook published in March. To read the full version, click here >
For more articles by Cedric Scholtes, click here >
For more articles by Jenny Yiu, click here >