Stories on Italy continuously hit the front pages, many pointing to the fact that the country has entered into a technical recession, while others allude to the political fight that may have risen between the two ruling parties: The Five Star Movement and the Northern League.
Although both stories may be reason for investors to get cold feet and sell Italian assets, is seems that until now markets remain sturdy and feel quite comfortable sitting on a ticking bomb that is going to explode sooner or later.
Nobody can deny that the Italian economy entered a technical recession the second half of last year, contracting by 0.2% in the fourth quarter and 0.1% the quarter before. Data that have recently come out are not reassuring, and yesterday’s PMI reading below 50 indicates that the contraction is real and it may last longer than expected.
The slowdown, however, is not deterring investors and while Italian sovereign bonds remained flat since the beginning of the year, the FTSE MIB has rallied by 7.7% YTD, indicating that investors continue to take advantage of convenient valuations of Italian assets compared to their European counterparts, although a recession has already started.
The 10-year BTP yield has rallied significantly in the past four months. In October last year it hit a four-year high with a yield of approximately 3.68%, and fell to 2.58% by the end of January. We are talking of more than 100 basis points of tightening within just four months, and given that it is clear that the economy is not solid, it is possible to deduce that this rally has been mainly due to the fact that the market believes that tensions between Italy and the European Union have settled.
But have they?
The budget agreement between the EU and the southern European country has moved bargaining power from Brussels to Rome. In short, Italy won: while the EU wanted the deficit for 2019 to be lower than 2%, Italian politicians have been able to arrive at compromise figure of 2.04% which is above what the EU initially envisioned. This has been perceived as a victory in Rome and the rhetoric of the two parties against the EU did not soften after that, as immigration policies are still at the forefront of discussions.
On the top of that we find an unsustainable political equilibrium between the two ruling parties, Italian citizens are increasingly warming to the idea of early elections in order to arrive to a sole winner that will unify the central power under one political leader and a clearer political direction.
All the above, together with a technical recession, constitute a very high risk for investors, which will ultimately result into lower BTPs. It can be said that a contained sell-off already started last week, pushing 10-year BTPs 20bps higher to touch 2.8% today.
We believe that if new elections are held then 10-year BTP yields will likely touch 4% as the anti-EU Matteo Salvini is leading in the polls, indicating that more conflict between the Mediterranean state and the EU is very likely.
The real trade opportunity here, however, is short-term Italian sovereigns (up to a duration of three years) as they can fall faster than longer-term maturities because the risk of new elections will be looked upon a short-term risk. That could offer opportunity to investors to take advantage of higher rates that will most likely stabilise after the elections.
