22-02-2013
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Insight
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Kommer van Trigt
The chances of a new government committed to the structural reform that Italy desperately needs are low. But the outlook for the country’s bonds is not as bad as the fundamentals might suggest. Kommer van Trigt explains.
Speed read
Expectations for election outcome are downbeat
Bonds could benefit from relief rally after election even with a less-than-stellar outcome
Neutral Italian bonds: until election tail risk is removed
Italian bonds are more attractive than Italian fundamentals
Economy doesn’t need austerity—it needs structural reform
Yield levels on Italian bonds are appealing—but beware high volatility
ECB still a major force in reducing tail risk
There is little prospect of Italy’s 24-25 February election producing a government willing and able to push through the structural reform that is desperately needed to revive the economy, says Kommer van Trigt, who oversees Robeco’s aggregated fixed-income mandates. But the outlook for the country’s bonds is better than might be expected.
What is the likely outcome from voting this Sunday and Monday, then? It is a very tight race, and many outcomes and permutations are possible.Although publishing poll results is not permitted in the final two weeks of an election campaign in Italy, the likeliest outcome is that the center-left coalition led by the sober Pier Luigi Bersani will win a majority in the lower house, the Chamber of Deputies. That said, a narrow victory for disgraced former prime minister Silvio Berlusconi cannot be ruled out.
“The big issue is what happens with the Senate [the upper house],” say Van Trigt. “There’s a clear chance there will be no working majority there.”In short, there is serious potential for instability and continuing uncertainty. No wonder markets are twitchy.
Base case is weak government with small majority
But Van Trigt isn’t convinced that the less-appealing scenarios—such as a hung parliament or more elections later this year—will materialize. “We expect a weak government with a small majority,” he says.
Then again, more positive outcomes are not on the cards either. “The chances are very low that there will be a convincing mandate from voters for structural reform going forward,” he adds.
The economy desperately needs structural reform
Yet that is precisely what Italy desperately needs. Mario Monti’s technocratic government, which resigned on 21 December, was tasked with stopping the country’s economic and fiscal decline. But progress in implementing reform was modest.
To be fair, Monti did achieve what Van Trigt calls “some good things” in this respect, including “ambitious” pension reform (which targeted early retirement and moved all workers into the contribution-based state pension) and the widely hated IMU property tax. “This measure really had substance,” observes Van Trigt.
“We like Italian bonds. We’re not so enthusiastic on the country or on the outcome of the elections”
Monti’s focus was on increasing revenues, which meant that he did not address government spending. Nor did he make much progress on increasing competition or challenging protected economic interests. “There, nothing has changed,” says Van Trigt.
Moreover, the focus on tax increases has resulted in demand having been well and truly sucked out of the economy.
A toxic cocktail: contracting GDP and massive debt
So as it heads to the polls, Italy is suffering from the unhappy combination of a contracting economy and huge debts. Not only has there been no growth for a decade—the economy is smaller than it was in 2001—the economy has shrunk for the last six quarters. Nor is the pain over: the IMF forecasts a further 0.7% contraction this year. Unemployment is over 11% and more than 36% for the under-25s.
At the same time, Italy has the second-highest ratio of sovereign debt to GDP in Europe at almost 130% of GDP. And at around EUR 2 trillion, its debt pile is the third-biggest anywhere—only the US and Japan are more indebted. This year, it needs to refinance more than EUR 400 billion.
True, there are one or two positives. The level of household and business debt is relatively low by international standards, and personal savings are high, giving the sovereign some scope for domestic funding of its hefty debt requirements. But that is a small consolation.
In short, Italy is in troubled waters. “If nothing changes, debt to GDP will get bigger each year,” says Van Trigt. “The only way to turn it around is structural reform.”
But, as we have seen, the election is unlikely to produce a decisive vote for a government prepared to implement difficult and unpopular structural reforms. “These are all very difficult issues for a new government that does not have a working majority in the Senate,” says Van Trigt. “Looking ahead, it is difficult to outline a convincing story that debt/GDP will be decisively addressed by structural reform.”
Given this mix of unfavorable politics, disturbing debt dynamics and a shrinking economy, perhaps it is no surprise that the portfolio’s managed by Van Trigt are neutral on Italian bonds as the elections approach. And yet he is actually pretty upbeat on the prospects for the world’s third-largest bond market after the elections.
More positive on Italy’s bonds than Italy’s economy
It is fair to say that Van Trigt is more positive on Italian bonds than on Italy. “We like the bonds. We’re not so enthusiastic on the country or on the outcome of the elections,” he says.
So what’s the appeal of Italian sovereign paper? First, there is the relatively high level of yields. The ten-year bonds offer a yield of around 4.5%. That compares with just 1.6% on German paper with a similar maturity. “Italy is clearly still one of the few markets where yields are attractive,” he says.
Second, there is the support of the ECB, which remains committed—in certain circumstances—to buy bonds of so-called peripheral countries such as Italy in the secondary markets.
For Van Trigt, the natural comparison is with France. Ahead of the 2012 elections, markets were afraid of a socialist government. But since François Hollande’s election, French government bonds have performed strongly.
That may be so, but even though Italian debt is attractive, don’t expect a smooth ride. “There will continue to be volatility, driven by political and event risk,” warns Van Trigt.
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