Robeco: Italy's Budegt Deficit could rise above 3%

Main market events

Peripheral spreads initially tightened in the past week, global risk sentiment improved after the U.S. mid-term elections cleared mostly as expected. Generally this was seen as a supporting outcome for risk assets as a split Congress indicates a status quo for current policies. Later in the week the Italy-Germany spread started to drift somewhat wider as the EC judged the outcome of the proposed Italian budget to be far more detrimental to the fiscal deficit than envisioned by the government.

Italy

The string of disappointing Italian news continued this week with composite PMI falling below 50 and the EC reporting that Italy’s budget deficit could rise above 3% in 2020. We do not expect that the Italian economy is poised for recession. PMI’s can be volatile and can be overstating or for that matter understating actual growth. However political uncertainty and rising Italian bond yields increase the chance for a further slowdown in growth. Slower 2019 growth also adds to the chance that the Italian target deficit of 2.4% will be reached even before fiscal spending measures are implemented. This could further complicate the stand-off between the Italian government and the EC. But given the political back drop of rising populism we believe that the EC could aim to avoid a too confrontational stance. So our base case remains that there will be an agreement between the EC and Italy, based on a soft fiscal adjustment path. Finance minister Tria did suggest that the 2.4% target deficit is a maximum and the government would adjust spending if growth would disappoint after all. Given the Italian government growth projections, at 1.9% for 2019, are significantly higher than those of the EC, this could indicate a possible opening towards a compromise.

ECB

In a speech before the Irish parliament on Thursday ECB president Draghi acknowledged economic data being “somewhat weaker” recently, but he remained confident on the economic expansion and on more permanent effects becoming a driver of wage growth. Forward guidance would be the main policy tool if “things were to go worse”, according to Draghi.

Robeco Euro Government Bonds

We have reduced the Italian overweight as the Italy-Germany spread is trading close to the bottom of the recent range and risks to growth are increasing. As we are overweight in 5 year Italian bonds there still is a slight bias towards a relatively constructive spread development. Before increasing Italian exposure again we would need to see some confirmation that the discussion between the EC and the Italian government is developing in the right direction.

We maintained an overweight in Spain and Ireland versus underweight in Portugal and France. Currently the fund is 38% invested in peripheral bonds, slightly below the index level as expressed in market value. Year-to-date the fund’s absolute return is -1.24%*.