The planned budget deficit, initially expected to be in the region of 1.6-2 per cent of GDP, was set at 2.4 per cent for the next three years. Finance Minister Giovanni Tria has ultimately given in to pressures from both Lega and 5Star and made room to finance the electoral pledges on citizenship income, pension reform and tax reductions.

The focus on spending rather than on productivity-enhancing measures impairs previous efforts to reduce the country’s deficit and debt burden, and goes against the pledges made by Mr Tria to investors and to the European Commission.

More importantly, the country’s long-term debt sustainability will now be heavily reliant on a very optimistic growth scenario materialising. Judging by the latest, softer than expected PMI releases, the outlook for Italian growth remains challenging. Even a minimal slowdown in GDP growth would set the country’s debt-GDP ratio back on an upward trend.

Italian assets come under pressure

The immediate market reaction has not been kind on Italian assets, and rightly so. Italy is now on a collision course with Brussels, and the Commission will no doubt be critical. Reviews by both Moody’s and S&P are also expected in the coming weeks. A one-notch downgrade by both appears probable at this point, potentially in conjunction with a negative credit outlook.

While the dust should settle in the next few days, BTPs will remain volatile. The headlines that emerge as the negotiations with the Commission take place will drive temporary sentiment. The spread between BTPs and Bunds should come under further widening pressure as a result.

European credit markets could offer solace

Credit markets, on the other hand, should be able to better navigate the volatility, even in the event of a one-notch downgrade of the sovereign rating. While Italian corporate bonds won’t be immune to BTP moves, correlation between the two has been trending downwards over the past few weeks. Credit spreads have reacted in an orderly fashion to the budget announcement, with little sign of panic. European investment grade spreads have already widened considerably since the beginning of the year, and should provide a valuable cushion for total returns in the volatile and uncertain months ahead.

David Simner

David Simner

Ario Emami Nejad

Ario Emami Nejad

Assistant Portfolio Manager