Sunday, October 23, 2016

Markets: A Whirlwind Tour of Worldwide Forces of Movement in the Week Ahead

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....MORE