Equity markets sold off heavily over the last 24 hours with the S & P 500, the Nikkei and the Hang Seng Index losing around 4 percent each. European equity markets have opened down 1.5 percent today, adding to Wednesday’s 1.5 percent pullback. Volatility as measured by the VIX index – Wall Street’s so-called fear barometer – has surged by 40 percent to 23 percent.Read more
Italy’s budget deficit caught markets off guard
- The new Italian government announced it would allow its budget deficit to increase to 2.4 percent for the next three years, catching the markets on the wrong foot as they anticipated a maximal increase to 2 percent.
- The official draft budget figures were not yet published when this issue went to press, but Italy's finance minister stated that the budget would reduce government debt as Italian growth should increase over the next two years.
- European markets went into a risk-off mode and sold off, but no international contagion was observed. Italian and Italy-related assets suffered the most.
- We increased the weight and duration of government bonds in our portfolios over recent weeks and positioned them rather close to the benchmark given the current uncertainty around Italy, Brexit and the U.S.-China trade war.
What caused the turmoil in Italian assets?
The announcement of a new budget plan by the Italian government last Thursday (September 27), citing a budget deficit of 2.4 percent of GDP for the next three years, caught markets off guard. It seems that most market participants anticipated a deficit close or even slightly below 2 percent. As the new, higher figure is in a range where the debt reduction is likely to be stopped, a trend which prevailed since 2015, the markets reacted negatively. So far, negative reactions appear to be limited as a debt increase can at least be ruled out at this deficit level. Yet, the relatively high deficit made clear that Finance Minister Giovanni Tria, who markets perceived as the guarantor of a moderate budget, was unable to deliver on his pledge to keep the deficit at least below 2 percent of GDP. Mr. Tria was cited to have considered resigning from his position but later announced to stay in order to prevent a further blow to Italian assets. The market’s confidence in Mr. Tria’s ability to temper the governing parties, however, seems markedly diluted. The new official budget draft was not yet published when this issue went to press and yesterday, Mr. Tria gave an interview stating the new budget figures will show a debt reduction by 1 percent per year – based on the assumption of 1.6 percent growth for 2019 and 1.7 percent for 2020. More growth would definitively be an important sign for investors and the right track for the country. Yet, we doubt that Italy’s economy can achieve such growth. The latest positive wave of economic growth seems to abate in Italy and the country’s sentiment indicators rather point to a real growth of only slightly above 1 percent, instead of the 1.5 percent forecasted by most economists at the beginning of the year.
Italy’s upcoming budget negotiation with the EU will cause further turbulences
Nevertheless, Italy faces a rocky road ahead (see timeline in Table 1). Most of the budget outlined so far does not seem to comply with EU rules. Moreover, difficult negotiations with the EU are likely to take place during the upcoming months, especially as it seems that only a few budget items stand for sustainable growth, while the majority of items appear to lead to higher social spending. However, we believe that the EU Commission and Rome could agree on a slightly lower deficit, as it is still within the range already claimed by other countries (above all France, see Chart 2 on historic and projected budget deficit). Also, it will be important to see how the rating agencies will react to the new budget and if they believe in Mr. Tria’s growth figures and debt reduction plans.
New polls will show who can convert the budget expansion into votes
In the political sphere, we expect a further shift in voter preferences due to election promises, some of which have hardly been implemented. This is likely to put the coalition once again to a severe test. The Lega currently has very good momentum in the polls, with a voter share of around 33 percent. Its coalition party, the “moviemento 5 stelle” (M5S), can only count on 28 percent of voters. Lega’s Mr. Salvini is able to score big points at present with his clear anti-immigration platform and needs no budget money for this. If this trend prevails, we see an elevated chance of snap elections for next year, one in which the “united right-wing bloc” (consisting of the League, Forza Italia and Fratelli d’Italia) could command a majority in parliament. Given the current polls, M5S would then need to brace itself for a clear loss of votes. From a medium-term investor’s point of view, a strong “united right-wing bloc” would be a positive sign as it would then apply the brakes to the cost-intensive redistribution so that public finances would be steered into calmer waters as a result.
Moderate, rational and mainly local market reaction
European markets reacted in an expected risk-off mode. Italian or Italy-related assets suffered the most (i.e. Italian bank stocks, the MIB index, European banking sector, and Italian government bonds) while the international impact was moderate so far and the U.S. equity markets hardly moved on Friday. The spread between Italian and German government bonds widened but did not breach the stress levels we saw earlier in the year. Unsurprisingly, the euro weakened against the U.S. dollar and the Swiss franc. So far, we see very little contagion in international markets.
Uncertainty for longer
The market moves were hardly strong enough for asset allocators to be able to exploit them by engaging in specific positions or that stressed assets became very attractive at current levels. Given the persistent uncertainty that the Italian budget process poses, it makes sense to balance the portfolio for a period of heightened European risk by going longer duration on the government bond side or generally increasing exposure to safe haven assets. Our model portfolios are just marginally underweight bonds and we already started to increase the weight and duration of government bonds over the course of the last weeks. We keep our neutral risk preference for the time being, managing portfolios relatively close to benchmark until we will have more clarity regarding the Italian budget and other risks such as the U.S.-China trade war, details about Brexit or the U.S. sanctions against Iran.