Italy holds ~$2.7 trillion in public debt, and global investors are worried that a new government could implement policies that would weaken the country’s credit status. Though a sovereign debt crisis does not seem probable at this point, bond markets are suggesting that risks are rising.
By Brian Nelson, CFA
We do not want investors to be worried by events unfolding in Italy (EWI) of late, as they may not be any more significant than the impact of Brexit (EWU) on equity market returns during the past few years. We can’t cast a blind eye to developments either, however, as Italy’s sovereign debt is not-at-all small by any country’s standards (it’s the third-largest in the world), and the political uncertainty is contributing to modest unrest in the sovereign credit markets.
We think investors have started to guard themselves against a very, very small probability of an adverse event that may cause contagion within the global banking system but given the long duration of Italy’s credit profile (its average debt maturity is ~7 years), we’re not sure the probability of a liquidity crisis is meaningful at the moment, even if expectations for continued deterioration of credit health cannot be ruled out.
Here are the rating agencies’ latest stances on Italy’s sovereign debt, courtesy of Reuters:
Moody’s has placed Italy’s “Baa2” rating on review for a possible downgrade, citing pledges in a government pact signed by the anti-establishment 5-Star Movement and the far-right League to increase spending, cut taxes and scrap a key 2011 pension reform.
S&P’s affirmed Italy at “BBB” on April 27, warning that the rating would come under pressure if a new government strayed from the path of budgetary improvement or unwound past reforms.
Given rising sovereign bond yields on Italy’s debt, it is clear the credit markets are already reacting negatively to political developments in the country, and while a downgrade by the rating agencies may do nothing more than confirm the market’s moves, any further downgrades won’t be positive by any stretch given the corresponding increase in borrowing costs on a rather large sovereign debt position. Italy’s two-year bond yield had been unusually low at -0.172% (negative 0.172%) at the start of May, and it now yields ~0.981%.
According to Moody’s, Italy has a “very high public debt ratio of over 130% of GDP,” and by any measure of risk, the country’s cost of borrowing should probably be much higher than it currently is, even after the recent rise (negative interest rates made little sense, in our view). We don’t think investors should overreact to the developments in any way, however, and we continue to monitor news flow regarding the implications of a new government in Italy, implications on its sovereign credit quality, the health of the euro as a currency, and the composition of the European Union.
Italy is the third-largest economy in the Eurozone and eighth-largest in the world, with nominal GDP of $2.05 trillion in 2018. The country is the eighth-largest exporter in the world, with Germany (EWG), France (EWQ), and the US (SPY) as its top three trading partners. The country’s economy was among the most negatively impacted by the combination of the credit crunch of the last decade and the European debt crisis that subsequently followed.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.