From Marc to Market:
There were two developments before the weekend that will likely spur a response in the week ahead.
First, while most were looking out for DBRS credit review of
Portugal, Fitch surprised by cutting Italy's credit outlook to negative
from stable. At the heart of the decision was concern about the
repeated delays and back loading of fiscal consolidation. The
disappointing growth, the non-performing loan burden, and the political
climate pose downside risks.
Italian bonds which had been underperforming Spain bonds had begun holding their own.
Last week, the benchmark 10-year bond yield fell 2.5% in Italy but
rose slightly in Spain. The divergence was sufficient to change the
month-over-month back into Italy's favor (+18.5 bp vs. Spain's +19.7
bp). Fitch noted that even if Renzi does not resign if the referendum
fails, the government may be weaker, and parliamentary elections are
scheduled for May 2018, and Euro-skeptic political forces are on the
rise (5-Star Movement won Rome and Turin in elections earlier this
year).
The surprise action by Fitch, coupled with EU demands that Renzi alters the draft budget may weigh on Italian bonds.
Italian bank shares rallied for three consecutive weeks, including a
sharp 7.3% advance last week. They may also be vulnerable if yields
continue to rise. Recall that DBRS put Italy on credit review with
negative implications in August. DBRS is the only one of the top four
rating agencies that put Italy in the "A" band. A cut would increase
the haircut the ECB imposes on Italian bonds used as collateral for
loans. The underperformance of Italian bonds relative to Spanish bond
may resume if Spain is able to avoid a new election before the end of
the year.
Separately, we note that the average of the last 10 referendum polls
in Italy with 1000 or more people surveyed was 35.3% supporting the
change of the Senate and 41.5% opposed. Most recently, former
(unelected) Prime Minister Monti came out last week siding with the
No's, as has a wing of Renzi's own party and the leaders of all the
opposition parties.
DBRS did not downgrade Portugal's rating or cut the stable outlook.
We had thought that at most, the only major rating agency to recognize
Portugal as an investment grade credit could have changed the outlook
to negative from stable. Investors had been anticipating that the DBRS
would do little, if anything in recent weeks, and were encouraged by
comments from the Finance Minister. The 10-year yield had fallen from
3.6% on October 7 to 3.14% last week. Below last week's lows, and the
yield can move back to 3.00%, where it had seemed to find an equilibrium
in August and early-September.
The second development was Canada walked out on the free-trade talks
with the EU when a small part of Belgium succeeded in throwing a wrench
into the works at the last minute. The agreement required the
unanimous consent of all EU countries. Belgium could not commit without
all five sub-federal governments and Wallonia objected. Its ultimate
objection was over the establishment of new courts to resolve disputes.
This is a controversial measure that is in the TPP and TTIP.
While Wallonia's objection is understandably frustrating for Canada,
but the walking out by the Canadian delegation, led by Trade Minister
Freeland was melodramatic. She is inexperienced in an inexperienced
government. The drama does not end the prospects for the deal and
leaders are scrambling for a workaround....
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