Elections in France and Holland pose risk

The forthcoming elections in Europe are set to pose a risk to investors in Italian bonds if voters in France or Holland elect populist leaders, according to Kames Capital’s senior fixed income investment specialist Adrian Hull.

Elections in France and Holland pose risk

While Italian bond yields have, until recently, remained surprisingly stable since the country’s landmark referendum in December, elections outside its borders in 2017 could intensify its existing economic problems if voters choose to break with consensus politics.

2016 wasn’t a good year for Italy’s economic fundamentals or credit ratings. For analysts and rating agencies the structural reform programme clearly has no momentum after December’s failed referendum result. Real economic growth has eluded Italy since 2000 and forecasts out to 2018 are below 1%. Thus, despite solid trade and current account surpluses, a continuation of growth below the increase in nominal debt weighs on Italy’s outlook.

Although the slow but solid process in bank recapitalisation is encouraging, this refinancing is set to leave the Italian government with an extra €20bn of debt. It’s not huge when the Italian government debt is already around €1.5trn but, in a low or no inflation environment and a budget deficit of around 2.5% of GDP, it is an unhelpful addition.

Given these headwinds it is counterintuitive that Italy’s 10-year bonds have traded so well since referendum, with the spread over equivalent German bonds consistently around 1.6% until last week. While I believe this reflects Italy’s position as a cornerstone of the euro and the EU project – as well as the “whatever it takes” approach of ECB President Mario Draghi –the elections in Holland in March and France in April may already be starting to impact on holders of Italian debt.

Markets are wary of Brexit-style events and too many UK commentators have predicted the ultimate demise of the euro. But with the imminent round of elections in Europe any break with consensus politics in Holland or France will ultimately prove to be Italy’s problem too.

As Italian bonds have drifted wider the risk of Geert Wilders or Marine Le Pen dominating market sentiment will lead markets to continue to reassess Italy – and investors in Italian debt have significantly more to lose than those in France or Holland.

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