Over the weekend Chancellor Merkel’s CDU/CSU won about 41.5% of the votes in the federal elections in Germany. However, with the Liberal Democrats (FDP) not being able to make it to the parliament, a CDU/CSU/SPD “grand” coalition of the largest parties looks the most likely outcome at this juncture. At the European level, we do not expect much change in this grand coalition scenario from Ms. Merkel’s current stance and continued support for weaker euro area member states.
With German election uncertainty largely out of the way for now, we expect near-term focus in the EGB market will remain on the political uncertainties out of the periphery and progress on institutional reforms namely: the Berlusconi case in Italy (much diminished after he decided not to withdraw his support to the Letta government), the reviews of the Greek and Portuguese programmes, and the banking union progress. However, none of these uncertainties are very different from what we have seen since the beginning of the year, to which market reactions have been muted. The one potential risk we see, in particular for Italian banks and Italy itself (given the relative information asymmetry on Italian banks), is the ECB Asset Quality Review in Q1 14, but it is probably too early to have an effect. With also a lack of surprise from the German election outcome, we expect to see progress on each of these issues over the course of Q4. However, this progress is likely to be only gradual as there will be a coalition negotiation period in Germany that may again slow down the progress. Overall, we believe core peripheral spreads (Spain and Italy) versus Germany will continue to perform well into year-end against these risks. Some other factors that we believe will facilitate this outperformance are outline below.
We think the Fed’s dovish surprise in the September FOMC meeting should benefit core peripheral spreads for several reasons. First, we note that even amid all the Fed tapering concerns since May, core periphery spreads versus Germany have behaved very well and never underperformed much, despite the sell-offs seen in other riskier asset classes, such as emerging markets and certain segments of credits markets. With the ‘risk-on’ mode returning even to the riskier assets which were under pressure, peripheral rates should continue to perform well too.
Second, even when Bund yields were rising, outright periphery yields didn’t rise as much, i.e., spreads versus Germany are now tighter than pre-taper period. When Bund yields have been rallying back, periphery yields have been rallying at least as much as well. At the time of writing, 10y Spain and Italy yields are both around 4.30%. Furthermore, the average yield on the outstanding marketable debt in both Spain and Italy are even lower at c.3.75%. Both levels are far away from being risky from a debt sustainability perspective.
Third, any ECB action to counteract the currency appreciation or the passive tightening of liquidity should bode well for peripheral spreads, particularly at the front end of the curve, which offers still very attractive carry (1y1y spreads vs Germany are at about 2.3%, and rolling down to 1% at the one-year horizon – see Figure 2). Last, the issuance burden on both Spain and Italy should be very limited going into year-end, with both countries having completed 75-85% of their gross issuance targets for the year.
Overall, we continue to see the forward part of the Spanish and Italian curves between 2y to 4y as attractive from a carry and roll down perspective.