Exposure rates of the Dorval Asset Management Range – 11th February 2019

Investors are faced with a whole range of concerns and from among them all, the question of Italy is now coming back to the fore.

Italian bond yields fell sharply after the agreement between the Italian government and the European Commission in December, but the country’s lacklustre economy – falling into recession in the second half of 2018 – is fuelling fears of further budget slippage and a fresh rise in public debt (cf. chart 1). Italy rates between one and three notches above junk bond status and does not appear to have much leeway at first glance, with ratings of Baa3 from Moody’s (since October 2018), BBB from S&P and Fitch, and BBB+ from DBRS. However, the country would have to be downgraded to junk bond by all four ratings agencies for its debt to stop being eligible for the ECB’s refinancing operations, which is highly unlikely. 

The European Commission recently cut back its growth estimates considerably for Italy to a mere 0.2% for 2019. Against this backdrop, there are two major questions: can the Italian recession get worse and become unmanageable, and how will the recession affect the country’s public accounts? Uncertainty is admittedly high, which creates hefty risk, but a number of key factors show that the Italian economy is less depressed than it may initially appear, bar an external shock from a hard Brexit type scenario. Italy is a more industrial economy than France or Spain and is admittedly hampered by world headwinds in this crucial sector. Meanwhile the new government has made few efforts to encourage renewed investment, to say the least.

Yet household confidence and business confidence in the construction industry – two highly domestic sectors – are still high and far from figures seen during the dark years of 2011/2013 (cf. chart 2). 

This situation can be attributed to a more buoyant job market, an increase in real wages and extremely low interest rates provided by banks to the private sector (cf. chart 3). Despite pressure on sovereign bond yields, Italian households and corporates currently have access to credit at interest rates of under 2%, which is virtually zero stripping out inflation.

Of course, we cannot conclude from this that everything looks rosy in Italy, and if world growth continues to slow and/or the current major political questions (Brexit, trade negotiations) lead to fresh upheaval, the Italian recession could worsen. Yet the most likely scenario remains limited budget slippage, with a deficit of perhaps 2.5% of GDP for 2019, instead of the 2% slated. Current yields on Italian debt seem to broadly price in risks, and even more (cf. chart 4). Lastly, it is worth noting that the Italian problem has not spread to other debt markets, which is an encouraging sign, with Spanish and Portuguese yields continuing to fall, pointing to improving credit risk.



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