Fixed income... volatility is in order
18 September 2018
The emerging debt markets had a very volatile August. Risk premiums reached a high of 375 bp on 13 August (284 bp at 31/12/2017) in parallel with the latest stall of the Turkish lira, which also hit a low against the US dollar at 7.23 (the lira has depreciated 50% against USD).
On top of the macroeconomic weaknesses, inflation above 16%, and a trade deficit of 5% of GDP, the government is losing credibility: Turkey has entered into a political conflict with the US that has brought with it trade sanctions on steel and aluminium. European countries' banking-sector exposures to Turkey as well as existing trade ties are not causing fear of contagion at this stage.
At 30 August 2018, the EM risk premium stood at 360 bp. The risks dragging down this asset class – trade and political tensions – persist, although there has been a slight détente since mid-August. For this to last, and support valuations, Turkey will have to address a resolution plan as quickly as possible, and Argentina will still have to show itself with the IMF at its sides to regain credibility on the markets.
Italy’s autumn budget is highly anticipated. To what extent will the Italian government use its fiscal room for manoeuvre up to the 3% ceiling imposed under the Stability and Growth Pact? The debt/GDP forecast before the government was formed was 0.8% for 2019, 2.2% would be the most “reasonable” figure. Whatever the deficit’s size, Italy’s primary surplus will be impacted, which is bad news for its debt trajectory, especially as the growth forecast has been revised down. The change in volatility trend for yields will increase the debt burden. While it is true that market positioning and valuations are offering more protection than in the days preceding the crisis in May, the marginal buyer will be difficult to find, particularly as international investors have sold record amounts of BTPs since May, while the ECB will stop its purchases in December.
Our fundamental view is negative, and we do not expect any short-term respite on the political front: Matteo Salvini’s party, the League, is topping all the polls. The draft budget will be submitted to the European Commission on 15 October after being presented to the Italian parliament. Recommendations from the EC will start to be issued in November. The risk of fresh elections cannot be ruled out.
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