With monetary policy tightening and pressure on household incomes, a recession is becoming more likely, which should put pressure on budget deficits.
Columbia Threadneedle Investments believes that the legislative elections in Italy pose short-term risks to Italian government bonds. James Lindley, fixed income portfolio manager at Columbia Threadneedle Investments, fears that a combination of the ECB halting net asset purchases, possible quantitative tightening and further interest rate hikes, as well as an untested center-right coalition, weakens Italian government bonds.
A widening of short-term spreads is expected
“With monetary policy tightening and pressure on household incomes, a recession is becoming increasingly likely, which should put pressure on fiscal deficits. Given the high level of inflation, it is unlikely that the ECB will be able to resume its bond purchases quickly, so buyers of Italian bonds will have to come from price-sensitive sources, which could demand higher yields. to be compensated for the additional risk,” says Lindley. He expects the transmission protection instrument (TPI) recently introduced by the ECB to contribute in the longer term to containing the spreads of the various countries. “But it is unlikely to be activated before the market is further under pressure,” adds the investment expert. The euro zone should tend towards pooling, which would be favorable to Italian debt. However, this could change with the evolution of the political context. The fund manager is also reserved when it comes to corporate bonds: “Italian corporate bonds have experienced a similar development to that of eurozone credit markets in general. We therefore see hardly any opportunities in Italy at the moment, especially given the heavy dependence of the Italian economy on Russian gas.”
Changing dynamics
According to the expert, the centre-right coalition tried to allay concerns that Italy was pulling out of Europe. However, a significant majority in the legislative elections could strengthen the more extreme voices within the center-right alliance, which would lead to a conflict between the European Commission and the Italian government. Since the eurozone crisis in 2010/11, Italy has apparently lost its attractiveness to certain investors. As a result, structural positions in Italy were rather weak. After Italy’s sharp underperformance at the start of the COVID-19 pandemic, it was believed that there was still plenty of room for maneuver on the upside, given the large debt buybacks by the ECB and the recovery fund. an equally important EU bailout, which is an important step towards debt mutualisation. “That dynamic has now changed,” Lindley said. The ECB is no longer buying Italian debt on a net basis and could, according to Lindley, start quantitative tightening in the near future. “In addition, the political situation has become more uncertain. While Europe’s resolve seems stronger than ever, we fear that a recession coupled with natural gas rationing will weaken that resolve and lead to further underperformance in Italy, given that the country is heavily dependent on Russian gas.”
Draghi’s Legacy
Italy remains of crucial importance for the euro zone project, explains the fund manager. Prime Minister Draghi has cemented this position by instilling confidence in European politicians and market players in the direction of the Italian economy and its commitment to Europe. This confidence has given Draghi the leeway to focus fiscal policy on areas that support the economy during the period of unprecedented energy prices, while bringing some longer-term benefits through reforms. According to Lindley, “Trust is one of the most important raw materials for markets. Elections could test that trust, both among policy makers and market participants.”