The yield gap between Italian and German debt—which reflects the extra premium investors demand for holding Italian assets over their safer European counterparts—in August reached a five-year high, according to Tradeweb. Yields on 10-year Italian bonds have climbed above 3% to their highest levels since 2014.
European equity funds, meanwhile, have posted outflows for 25- straight weeks, according to fund-tracker EPFR Global, while ownership of euro-area stocks in global portfolios has fallen to its lowest since the European Central Bank launched its massive bond-buying program in January 2015, according to data from the Institute of International Finance.
“Italy has hit sentiment hard,” said Richard Saldanha, an equity fund manager at Aviva Investors.
Investors fear Italy’s government could announce a budget this fall that puts the country’s debt on an unsustainable course and so amplify tensions with Brussels.
“I’ll be watching the Italian budget very closely. If that passes [smoothly], people will look at European equities again,” said Mr. Saldanha.
In a country expected to grow 1.2% this year, promises made in the new government’s coalition agreement, including a flat tax—a system in which everyone pays the same rate—a citizens’ income and pension reform, add up to between 4.5% and 7% of GDP of additional spending, according to estimates by UBS .
Fitch Ratings on Friday cut the country’s debt outlook to negative, citing concerns that fiscal loosening may leave the country’s public debt more exposed to potential shocks.
The stakes are high: Italy is the eurozone’s biggest government borrower. While foreigners and households sold Italian debt this summer, Italian banks were buying it at the fastest pace since the eurozone debt crisis. That means any losses in Italian bonds puts more pressure on the banks’ already modest capital ratios, driving them to buy even more debt, according to research firm TS Lombard.
Recent stress in Italian assets comes as the ECB phases out its bond-purchasing program by the end of 2018, traders say liquidity is worsening in bond-trading and the political stability of the eurozone has again been brought into question.
“A worst case scenario over the budget deficit could see another sharp widening in [Italian-German bond] spreads when the ECB is not there supporting markets like before,” said Mohammed Kazmi, a portfolio manager at Union Bancaire Privée.
Mr. Kazmi went into the year optimistic about Italy but said he exited his positions in the country’s bonds as soon as there were talks around Matteo Salvini, leader of the anti-immigrant League party, and Luigi Di Maio, leader of the 5 Star Movement, coming together to form a government.
He also been has been favoring U.S. credit over European credit exposure more broadly recently, in case the Italian weakness spills over into the rest of Europe.
The S&P 500 has outperformed the Stoxx Europe 600 by roughly 9 percentage points since mid-May in the aftermath of a leaked draft agreement of a government program that proposed the introduction of procedures within the eurozone to allow countries to quit the euro and said they would ask the ECB to write off €250 billion ($296 billion) of government debt.
The 5 Star Movement and League later said that the draft was out-of-date and details had changed significantly.
The exodus from European stocks has come despite solid economic fundamentals: the Citi Economic Surprise Index for the eurozone is now back in positive territory for the first time in six months even as the U.S. and Japan sit in negative territory, while second-quarter earnings for the Stoxx Europe 600 index are on track to grow 10%, according to Thomson Reuters data.
“Even if valuations in Europe are more attractive, you’ve had an absence of positive political developments,” said François Savary, chief investment officer at Prime Partners in Geneva.
Italian stocks, meanwhile, quickly went from the year’s best performers to among the worst.
In mid-May, Italy’s benchmark FTSE MIB index was outperforming the Stoxx Europe 600 by 10 percentage points for the year, but has underperformed it by roughly 14 percentage points since then. Meanwhile, May and June marked foreign investors’ biggest ever monthly outflows from the country’s debt, according to data from the European Central Bank.
While some investors may see this as an attractive entry point, others worry a crisis in Turkey’s markets could further aggravate troubles in Italy. Italian banks such as UniCredit are among the most exposed directly to Turkish debt, helping send the FTSE Italia All-Share Banks Index down 28% since May. Some investors worry that fractious politics in Turkey could deepen political divisions over migration in Europe, a hot button topic in Italy and elsewhere.
“The Turkish story has direct links to Italy,” said Grant Peterkin, a managing director at Manulife Asset Management. “I don’t think Italy is out of the woods yet.”
Write to Riva Gold at [email protected]