This weekend's Italian election is not attracting the same attention as votes last year in France and Germany - but that is why, suggests David Zahn, an unexpected result might provoke an outsized market reaction
Most polls suggest there will be no outright winner in this weekend's Italian general election, which is set to take place on 4 March. The most likely outcome is either a technocrat government or a grand-coalition - neither of which is likely to have a dramatic impact on bond markets.
It could be a different story, however, if one group were to win enough seats to form a government - particularly if that group were the coalition of centre-right parties currently riding high in the polls.
The final opinion polls published ahead of the election suggest the coalition of centre-right parties - which includes the Silvio Berlusconi-led Forza Italia - could win the most seats. In contrast to traditional centre-right dogma, the Berlusconi coalition's manifesto calls for increased spending and a larger Italian budget.
It currently looks unlikely to reach enough seats to win an absolute majority and yet, if it did creep over the line, that outcome could have negative repercussions on Italian debt. The country's central bank would likely be issuing more government bonds (BTPs) at a time when one of the biggest buyers, the European Central Bank (ECB), is scaling back its purchases of government debt.
Looking more widely, we have seen little evidence so far contagion from the global equity pullback at the beginning of February has spread into fixed income markets. In European corporate markets, there has been some modest volatility - more at the index level - and we have seen some spread-widening, but nothing that is overly concerning to us.
European sovereign bond yields are higher this year and have risen a little more quickly than we expected. We felt they would rise in time but, while economic growth has been strong in Europe, inflation remains quite low. That said, there are some signs of higher inflation coming through in the data.
ECB president Mario Draghi has indicated keeping eurozone inflation just below 2% is a long-term target, which implies the central bank could be comfortable with inflation rising above 2% for a short period of time. As such, our feeling is the bank's governing council will want to see inflation rising higher before it considers less accommodative monetary policy.
Our current assumption is eurozone quantitative easing (QE) will continue into next year and the ECB will likely aim for its first interest-rate hike in 2020. Markets are, however, starting to price in hikes even sooner. That is probably partially because some investors have been expecting yields to increase for quite some time. Understandably, people want to make sure they do not miss out, but we think the market is getting a little bit carried away.
In general, the underlying fundamentals for both investment-grade and high-yield corporate credit in Europe remain positive. European companies in general appear to have good balance sheets and borrowing rates are low. At the same time, there is some inflation coming back into the system in Europe, so companies are able to pass through price increases to customers. We see all of this as positive for corporate bonds in the region.
On the other hand, some valuations on the credit side have become slightly stretched. The widening spreads on the credit side may reflect a normalisation to compensate for some of the risk investors are taking. While we recognise the uptick in equity-market volatility may have contributed to the stretched credit valuations, uncertainty over the ECB's monetary policy path seems also to be playing a role. In particular, investors are watching for clues as to the timing and size of the ECB's QE tapering.
The current QE programme is due to expire in September of this year, and it seems unlikely the ECB would end it abruptly then. So we think an extension - possibly featuring further tapering - is likely. That said, we do not expect the ECB to make an announcement about its tapering plans until at least the summer.
Draghi has indicated any decision on the future of QE would be driven by data. Waiting until the summer would give the central bank policymakers more data to consider. Meanwhile, our analysis suggests other considerations could affect the timing of interest-rate hikes.
The ECB has previously indicated it would not hike rates immediately after ending the QE asset purchase programme. Assuming the ECB extends the programme into early 2019, a moratorium of six to nine months would take us very close to the end of Draghi's tenure as ECB president. It is likely the ECB would delay an interest-rate hike until the arrival of a new ECB president, which in practical terms pushes the first rate hike into early 2020.
We have been monitoring the ECB's buying habits since it cut the size of its asset-purchasing programme from €60bn (£53bn) a month to €30bn a month starting in January 2018. Although the total monthly purchases have halved, the amount of non-government assets bought - including covered bonds or corporates - has dropped only slightly from €10bn a month to around €8bn to €9bn a month.
So, government bonds have felt the bulk of the reduction in purchases. If QE continues into 2019 as we expect, it should likely remain focused on private assets.
Finally, the low volatility in European fixed income markets seen over the last 12 to 18 months is probably behind us. Although we do not think we are heading into a period of a high volatility, investors should accept there will likely be short bouts of it. We consider volatility an opportunity to invest if we see spreads widening on names we think are solid.
David Zahn is head of European fixed income at Franklin Templeton
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