In their failure to make a clear choice between Silvio Berlusconi, a TV comedian and the centre-left candidate Pier Luigi Bersani – who had carried the market’s hopes – Italian voters did at least make one thing clear on Monday: their outright rejection of Mario Monti. In the 24 hours since the Italian polls closed, as investors struggled to digest the uncertain outcome, they clung to one obvious thread: this is a bad result for those investors that had grown complacent about an early and benign end to the eurozone sovereign crisis.
Jim Reid, strategist at Deutsche Bank, stresses that one of the standout features of the election is that Monti polled at only around 10% nationally.
“It’s fair to say that his policies/views would have been supported by virtually all the main EU players, including the ECB,” he says. “Yet only one in 10 Italians are prepared to back him.
“The voters have certainly made it clear that they are not prepared to accept the combination of austerity and negative growth that the EU’s policies have encouraged.”
Reid draws the wider lesson that “either Europe needs to change its bias or the voters will cause major issues going forward”.
Bond investors have been quick to take the obvious trade: sell Italy and buy German Bunds. Indeed, in putting on this play, Barclays analysts point out that bond investors were not as badly behind the curve as the early pollsters on election day, who wrongly called a victory for Bersani.
“The re-widening in Italian bonds since the end of January had already seen five-year and 10-year Italian bonds underperform their German counterparts by 85 basis points in both areas.”
The immediate aftermath of the election saw another 80bp widening in the spread.
More doubtful, in time, might be the immediate intra-periphery moves, which saw five-year Italian bonds cheapen 63bp versus Spain, and 10-year Italian bonds give up 76bp to Spanish equivalents. Have bond investors forgotten that, last year, Spain was the prime candidate to request assistance under the ECB’s OMT programme?
In the first weeks of 2013, investors – including, so several bond traders tell Euromoney, many US based credit funds chasing yield – had gone back into Spanish government bonds, pushing foreign ownership of Spanish bonds back up to 20% of the market from as low as 10% to 15% in mid 2012. Will these investors regret putting on that trade?
UBS economist Reinhard Cluse points out that fiscal consolidation, rising unemployment and banking sector deleveraging will likely continue to take their toll on Spanish growth this year and next, threatening the country’s chances to reach its deficit target of 4.5% of GDP for 2013 and 3% in 2014.
However, markets have taken a sanguine view with 10-year yields, rising 13bp to 5.294% on Tuesday, compared with a record high of 7.75% reached in July, before the ECB was forced to unveil its crisis-combating package.
Poor economic backdrop
Economists reckon yields are likely to remain structurally under pressure, given the country’s poor economic performance. The European Commission forecasts that GDP could contract in the same order of magnitude this year as the 1.4% decline in 2012, while austerity only began to bite in the second half of last year. If aid to recapitalize Spanish banks is included, the fiscal deficit could be as close to 10%, throwing into sharp relief Spanish solvency risks.
Italian voters may have delivered a rebuke to Monti but he has left the country the legacy of a relatively healthy fiscal position. True, Italy’s large debt stock makes it vulnerable to persistently high interest costs but at least it is not still digging itself deeper into the debt hole. Michael Gavin head of asset allocation at Barclays points out: “Our economists believe that Italy is positioned to run a primary (non-interest) budget surplus of 3% of GDP, even under our forecast of weak economic activity. The heavy budgetary lifting has mainly been completed, and the task before the incoming government is to defend the consolidation already undertaken.”
Cluse warns: “We expect the EU to grant Spain some lenience and adjust the fiscal targets, but nevertheless ask for additional austerity, at a time when the social fabric is already stretched and the government’s popularity has fallen. Consequently, we expect Spain’s consolidation path to remain difficult and continue to cast a shadow across the wider eurozone.”
Even excluding bank recapitalization, Spain was still running a fiscal deficit close to 7% of GDP in 2012. UBS’s base case is that Spain will have to apply to the ECB’s OMT programme in the second half of this year, and while its bond yields might narrow in the near term, UBS expects this to reverse before long and Spanish yields to rise in March and April, paving the way for a request.
Another economist at a European bank says: “What we have seen up till now is remarkable complacency with respect to investors in the Spanish government bond market. There is now a risk of the market focus coming back to Spain.”
Gilles Moec, Europe economist at Deutsche Bank – who refuses to punt on whether Spain will request the OMT or not – says the Italian vote has increased the political hurdles for Madrid requesting the OMT, which mandates sovereigns to embark on fiscal and structural reform in return for ECB bond-purchases at the short end in the secondary market.
“The Italian vote has made the request for OMT harder,” says Moec. “And what we are seeing in the market is a re-assessment of the eurozone risk premium, as markets had a naive view on the ECB’s crisis-fighting mechanism. It’s not a simple framework.”
Asked if Berlin and Brussels would ease up conditions in return for the support package, the analyst adds: “If the conditions to ask for support are made easier, then markets are less likely to trust the efficacy of the programme.”