One of the biggest surprises so far this year has been the strength in the Italian economy. In Q1 2017 Italy posted a 0.4% increase in real GDP, the strongest quarter since the European Sovereign Crisis. Meanwhile composite PMIs are reaching new highs, unemployment is finally falling (now 11.6% down from a peak of 12.6% in 2014) and inflation has picked up to 1.5% from around 0% where it has been for over two years.
True, total government debt to GDP is still high at 132.6%. For this ratio to fall, nominal growth must exceed the budget deficit (2.4% of GDP) and there is a small and rising chance that this can be achieved in 2017.
However, politics as always is getting in the way; political developments is certainly the key negative from the rating agencies’ standpoint right now. The failure to reform the senate last year was a step back in the reform process and the current electoral law reform is progressing slowly.
For Italian government bonds this means volatility over the next few months. The latest day an Autumn election can be called is 3 September, for a 22 October vote. And the precondition is the electoral law being passed in July. Irrespective of when the vote takes place, I think it is extremely unlikely that leaving the EU/Euro as a popular policy would get off the ground (around 67% are in favour of using the euro, 15% are opposed and the rest don’t know) but this won’t stop markets being concerned about it.
Where this differs from our experience in France earlier this year is that the current spread on Italian government bonds (over bunds) is already pricing in some political risk. The Italy/Bund spread is currently 200bps, having been as low as 100bps last year. Our view currently would be to buy on further weakness rather than chase the market. We expect there to be some good opportunities to make money through this election period, keeping in mind the potential for volatility.