David Roberts

Why we continue to avoid Italy

David Roberts

Just hours before Italian politicians confirmed a target budget deficit of 2.4% for 2019, the Treasury auctioned over €4bn of five- and 10-year bonds. Demand, especially for the 10-year maturity, was higher than at any time since May.

And then the bad news, that the coalition would risk defiance of the European Union (EU) and pass a budget to threaten Italian debt ratings and the overall debt to GDP ratio. Amazingly, investors had bought this 10-year risk at a yield of 2.9%, well below the 3.25% similar bonds were issued at in August.

What happened? For most of the summer, information suggested US hedge and index funds had been “shorting” Italian risk. During September that was a painful trade and the September auction was an opportunity for them to reduce their short ahead of what many non-Europeans expected to be a positive moment for Italy.

The only word I can use to describe what happened next is oops. In market parlance, some of our hot money friends seem to have been “topped and tailed”, buying at the top and selling at the (so far) bottom. Since the deficit announcement, Italian debt has fallen dramatically: indeed, the market value even of the small amount of Treasury bonds (known as BTPs) auctioned has dropped over €100million.

Italian 10 Year Bond Yield 

 

Source: Bloomberg, as at 04.10.18

This may only be Mark to market pain of course. However, I would rather be in a position to buy bonds today, after the big risk event than take the gamble that has failed for many.

I remain zero weighted to Italian sovereigns, continuing to favour shorts in French debt relative to German and Norwegian as a low volatility way to make money from the situation.

In the next two weeks, it is likely the EU will reject Italian proposals, leading to further weakness and volatility. The coalition, I believe, will then reduce the deficit target to less than 2%, blame the EU but note they are still prepared to spend more money than the previous regime. Categorically, it is in no one’s interest to see Italy either forced out of the EU or leave on its own account.

I do think Italian debt will begin to look attractive at some point. It is likely we see some form of short-term resolution and EU budget approval in November. For now though, there is little incentive for the European Central Bank (ECB) to support the market, a theme I wrote about in May, and anyone expecting that soon is likely to be disappointed. At best, you may hope for some comment that officials are aware of or are monitoring the situation.

Will this delay the end to quantitative easing (QE) purchases? I think not. As recent events showed, Italy was still easily able to access the market. As long as that continues, the ECB will be happy and, of course, ending QE could push-up Bund yields as much or more than BTPs, narrowing the all-important yield gap.

If the pain is felt by a few US hedge funds, not only the ECB but perhaps the Italian government will also be happy.

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Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Friday, October 5, 2018, 11:07 AM