Euro peripheral sovereign debt
The regional elections in Italy in early 2020 did not produce the "Salvini wave" feared by many. The ruling Democratic Party (PD) won the day in Emilia-Romagna on January 26. Investors were closely watching how the League fared in this region, traditionally a left-wing stronghold, with a surprise League victory seen as having national implications. Speculation about the election result contributed to the decline of the 10-year Italian sovereign spread vs. the Bund to 139 bps on February 3 from 164 bps at the start of the year.
Many hurdles remain to be cleared, but the risk of a government crisis in the short term has receded: the result in Emilia-Romagna reinforces our base case that the current PD/Five Star Movement (M5S) governing coalition should stick together this year.
Should Italy manage to record modest but positive GDP growth in the coming quarters (we foresee 0.4% for 2020 with risks tilted to the downside) and the governing coalition remain intact, then the 10-year spread for Italian bonds (BTPs) over Bunds could tighten towards 110 bps by end-June as the political premium on Italian sovereign bonds continues to be pushed down. In this scenario, the two rating agencies that still have a negative outlook on their ‘BBB’ rating of Italy (S&P and Fitch) might change it to stable, hence lowering the risk that Italy’s rating falls closer to high-yield status.
The Italian sovereign yield curve is mostly positive (from three years on), so Italian sovereign bonds could look attractive again to investors wanting to reduce their exposure to bonds that offer negative yields, as most sovereign bonds in euros currently do.
In Spain, after several months of political uncertainty, Pedro Sánchez of the Socialist Party won a confidence vote on 7 January that confirmed him as prime minister. He will govern in coalition with the left-populist group, Unidas Podemos. Spain’s economy has outperformed the euro area average for the past five years, with 2019 GDP growth at 2.0% (2.4% in 2018 and 2.9% in 2017) despite a protracted period of political uncertainty.
Reduced political uncertainty should provide a further boost to the domestic economy. In the medium term, however, some of the new government’s proposed measures (notably the partial repeal of labour market reform) could undermine the competitiveness of Spanish firms.
Taking into account the short-term positive catalysts for Italian sovereign bonds and the limited political uncertainty in Spain after the formation of a governing coalition there in January, we are moving to neutral from underweight on euro periphery sovereign bonds. Political risks cannot be fully ruled out, but since we think they will become more significant in 2021 than in 2020, we are maintaining our year-end forecast of 130 bps for the 10-year BTP/Bund spread and of 80 bps for the 10-year Spanish sovereign spread.