What Italy’s Recent Bond Auction Reveals About Debt Fears

Over a month after Italy’s populist government took office, debt fears are still commonplace as investors grapple with a potential for tax cuts and big spending. We think the likelihood of such sweeping changes to fiscal policy is low, considering how gridlocked the coalition appears to be, but that isn’t the only reason we think debt fears are probably unnecessary. A quick look at a recent bond auction and a measured analysis of Italian government finances reveal a landscape far different from common media portrayals. Italian debt is just one of many areas where Italy’s economic and political reality exceeds expectations. We think this is a bullish disconnect that bodes well for Italian and eurozone stocks.

At June 28’s bond auction, Italy’s Treasury sold €2.5 billion in 10-year debt and €2.0 billion in 5-year debt. Some coverage sounded a skeptical note because the bid-to-cover ratio, which tallies the number of bids per bond sold, fell to 1.26 for the 10-year Italian Treasury’s Buoni del Tesoro Poliannuali (BTP) auction, down from 1.48 a month ago and its lowest since January. The 5-year BTP auction’s bid-to-cover ratio was 1.34, the lowest in a year. That is one way to look at it, we guess. But here is another: A surplus of investors were willing to lend to a shaky, populist government widely feared to blow debt through the roof—and to do so at lower rates than they did a month prior. Plus, these issues refinanced maturing debt at lower rates. The 10-year notes auctioned on June 27, 2008 carried an interest rate of 5.1%. The 10-year notes issued two weeks ago, some of which replaced those maturing notes, cost just 2.8%. Similarly, on June 27, 2013, the Treasury sold 5-year notes at 3.5%. June 28’s replacement notes carried an interest rate of just 1.8%. In other words, a piece of Italy’s debt stock just got a bit cheaper.

Exhibit 1: Italian Bond Yields Near Their Lowest in Decades

Source: FactSet, as of 7/10/2018. Italy 10-year benchmark government bond yield, 2/1/1980 – 7/10/2018.

Cheaper Italian debt isn’t a new development. Funding costs have fallen for years. Debt interest payments’ share of tax revenue is 14%—the lowest in decades. (Exhibit 2) This topped 40% in the 1990s, a strong period for Italy’s economy and stock market. We think it is hard to argue Italy is uniquely burdened now. The Italian Treasury also extended its average debt maturity to seven years from three in the 1990s, locking in low rates. As a result, rates would have to rise much higher and stay there to be a problem. Rates are half what they were seven years ago—and they didn’t cripple then. They were higher still in the 1980s, when 10-year yields hit 21.7%, and yields remained north of 10% through the 1990s’ first half. If Italy could shoulder high interest rates three decades ago—like most other developed markets at the time—it likely can at much less onerous levels now.

Exhibit 2: Italian Debt Carrying Costs at Multi-Decade Low

Source: FactSet, Bank of Italy and Oxford Economics, as of 5/23/2018. Italy government interest payments as a percentage of tax revenues, Q1 1982 – Q1 2018.

At the risk of sounding dismissive, in our view, Italian risks seem priced in. They are too widely discussed to sneak up on markets. While sentiment is pessimistic, investors largely overlook the benefits of political gridlock and improving economic fundamentals. In a few short weeks, Italy went from one of the world’s best performing countries this year to underperforming. But it did so despite no material negative fundamental shift, in our view. Many folks fear the newly installed populist government, but the likelihood it is able to pass much of what investors fear is very low. The weak coalition between the antiestablishment Five Star Movement (M5S) and far-right League is already splintering over the Interior Minister’s (and League leader’s) proposed treatment of the Roma population.

Investors’ biggest fear—Quitaly, Italy leaving the eurozone and EU—also looks remote. This would take a constitutional amendment requiring a two-thirds parliamentary vote—the M5S-League coalition has 54%—though many members likely wouldn’t support a Quitaly measure.^[i] Both parties have walked back their euroskepticism to the point that leaving the euro isn’t in their governing platform. As for fear of populists enacting radical policy like huge spending bills, we’d suggest taking a look across the Adriatic^[ii] at Greece’s populist and socialist government—after making big threats and stoking fear, they moderated.

Meanwhile, Italy’s economy is growing steadily, even if it isn’t gangbusters. Manufacturing and services purchasing managers’ indexes show expanding business activity, and their new orders components indicate more ahead. Private sector lending and broad money supply growth also appear poised to pick up. With Italian banks recapitalized and shedding bad loans, there is room on their balance sheets to extend credit—more fuel for Italy’s economy!

Italy’s improved finances get lost in the day-to-day minutiae of rough and tumble Italian politics. It may not be obvious in the tumult, but Italy is far from the sick man of Europe many peg it to be. As more realize this—and the eurozone’s overall improving fundamentals—we expect the better-than-anticipated reality to boost Italian and European stocks.