Robeco: Peripheral Europe Update, week 35

Main market events

BTPs continued their extraordinary rally as acting prime minister Conte has been given a full mandate to form a substitute government made up of the Five Star Movement and PD. The market perceives this outcome to be favourable for BTPs, as a confrontation with Europe on fiscal spending is deemed less likely. The 10yr BTP yield could decline to below 1%, the lowest level on record. Italian bonds have returned 13.3% year-to-date, Spanish bonds 11.6%, Portuguese bonds 11% and Irish bonds 9%.

Italy

Investors were encouraged by political developments in Italy, even though, with growth remaining subdued, fiscal challenges remain large. As the new coalition is expected to be more conciliatory towards Europe than the previous government, prospects for relatively smoother 2020 budget negotiations seem more favourable. The room for fiscal leeway also has increased somewhat due to plunging borrowing costs. Rating agencies could find developments constructive as well. Next Friday September 6th, Moody’s (Baa3, stable) will publish its updated rating for Italy. In October, S&P (BBB, Neg) updates its review of Italy. If the new government is indeed formed, the risk of downgrades should decline. As 2020 budget negotiations and rating reviews actions were perceived as paramount risks for BTPs, recent developments should alleviate some of investor’s concerns.

ECB

With the holiday period drawing to an end, ECB speakers also returned to make headlines again. While hawkish governors including Lautenschläger, Weidmann and Knot warned against ‘overdone’ market expectations for the upcoming ECB meeting on September 12, in comes cases even suggesting that a restart of QE was not needed, the ECB’s Rehn reiterated that current economic circumstances warrant a package of easing measures. We interpret this as comprising a rate cut and a restart of net purchases. Admittedly, economic data in the Eurozone such as the European Commission’s economic sentiment indicator earlier this week, have started to show signs of bottoming out. But with Eurozone core inflation dipping back below 1% in August, hence continuing to show little sign of upward movement towards the ECB’s medium-term objective,  we believe more than a 10 or 20bp interest rate cut is needed to reinstate the ECB’s inflation targeting credibility.

Robeco Euro Government Bonds 

As political uncertainty took hold we reduced exposure to Italy early in August. As tensions eased this week, the fund added to BTPs again.  Moreover the fund is overweight Ireland, Portugal and Spain. Developments in Italy and expectations for a broad easing package at the September 12 ECB governing council should be supportive for peripheral spreads. The fund is 48% invested in peripheral bonds, which is 7% above the level of the index. Year to date the absolute return of the fund is 10.96%*. 

_{* Robeco Euro Government Bonds, gross of fees, based on Net Asset Value, 30 August, 2019. The value of your investments may fluctuate. Past results are no guarantee of future performance.}