Is Portugal expensive, or is Italy cheap?

When valuations in fixed income are this stretched, we must be on the lookout for overbought assets to avoid, and unloved assets offering a rare opportunity to pick up yield. Take 10-year Portuguese government bond yields, for example, which have fallen to a three-year low of around 1.65%. That is only 110bp wide of German Bunds, and some 15bp inside Italian BTPs. Based on pure credit fundamentals, Italian government debt trading wider than Portugal’s makes no sense.

Portugal has been a poster child of the broader European economic recovery. Rising investment and exports helped its economy grow by 2.7% in 2017, its fastest pace since 2000, and the country’s public debt dropped to 125.7% from almost 130% in 2016. But that debt-to-GDP ratio remains high for an economy overly reliant on tourism, and the Bank of Portugal sees GDP growth falling to 1.9% in 2019 and 1.7% in 2020.

Italy’s public debt burden, at just under 132% of GDP, is second only to Greece in the euro area, and its near-chronic need for economic reform is well-documented. GDP growth of 1.5% last year was nothing to write home about, but it was Italy’s best effort since 2010 and represents progress for what people tend to forget is a G7 economy, the Eurozone’s third-largest and one much better diversified than Portugal’s.

So whose Bund spread is wrong, Italy’s or Portugal’s? It’s actually a bit of both.

We know why BTPs are trading with a premium. Italy’s election last month saw a surge in support for the populist Five Star Movement and Northern League parties – see our blog ‘Wishing Upon 5 Star’ – meaning an anti-establishment, and by varying degrees anti-euro, party will be at the centre of whichever coalition emerges from the ongoing negotiations. The political risk premium being attached to Italian assets is understandable, but such events invariably lead to opportunities for investors as the spreads of certain credits, such as banks and corporates, are caught up in the general widening. There are a number of names in Italy that currently fit this category – we are invested in a few of them and are closely watching others for the right entry point.

While some Italian credits are trading cheap, Portuguese bonds are priced for perfection. Bunds are the most expensive and overbought asset we can think of in fixed income, so we are extremely wary of Portuguese assets given how tight they are trading to Bunds. Last May, Portuguese 10-year yields were around 3.5% with a spread of over 320bp to Bunds. With that spread now at just over 110bp, the market is telling us Portugal’s credit strength relative to Germany has improved by nearly two-thirds in the little under 12 months since.

Portugal and its fellow periphery economies have clearly benefitted from the broadening economic recovery evident in the euro area, not to mention the European Central Bank’s backstopping of the sovereign bond market, but a spread of 110bp reflects an amount of optimism around the next stage of European integration that we believe is misplaced. The source of that optimism can be traced back to the election of French president Emmanuel Macron last year, which fuelled hopes that a partnership with German chancellor Angela Merkel’s government would accelerate plans for “ever closer union” in the bloc. However, Merkel and other senior figures in Berlin were always lukewarm about Macron’s more ambitious proposals, such as a joint Eurozone budget, and Macron himself faces a significant challenge in proving he can push equally ambitious labour market reforms through at home.

Following the formation of Merkel’s grand coalition last month, which cleared the way for formal talks with France on further integration, eight northern EU states led by the Netherlands published a joint paper warning against “far-reaching transfers of competence to the European level”, adding that decision making should “remain firmly in the hands of member states”. There are major obstacles to further European integration in the short term, and the less integration there is, the less of Germany’s credit strength periphery economies are entitled to draw on.

Consequently we are generally wary of Portuguese bonds – sovereign, banks and corporates – for the time being, but there will be opportunities in sectors of the Italian market where political risk premium is overdone.