Not out the woods yet
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Article Type
Insights
Topic
Macro
Published
September 09, 2024
Read time
5 mins
Author
Luca Ferramosca, CFA
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Market gyrations have dominated August and are likely to persist through the last quarter of 2024. Historically, summer months have provided moments in which thin liquidity and returns from carry positions left investors complacently staring at sunny beaches on Côte d’Azur or Sicily rather than static price action on their screens. This year, however, has proved to be utterly different. Admittedly, recession fears and higher sensitivity to single US economic data print have taken centre stage, with safe haven flows permeating global markets and leaving no one unscathed.

 

While the market has almost entirely focused on a weakening US job market and was self-conflicting over the aggressiveness of the easing path developed countries’ central banks need to embark on, idiosyncratic fiscal and political woes of specific European countries have mulled “silently” in the background. However, as we entered September, the closely monitored end-of-year budget laws are seemingly poised to create the perfect storm. In addition to the usual preparation for the autumn fiscal update, member states such as France and Italy have been placed in an Excessive Deficit Procedure (EDP) by the European Commission (EC) and are required to submit a multi-year fiscal consolidation plan by September 20th. This plan is essential to test whether the public finances of those countries are progressing in line with new EU fiscal rules, which are mandating a minimal fiscal tightening of at least 0.5% of GDP each year until the deficit ratio falls below 3%, among other requirements. Meeting these fiscal adjustments under the EDP is seen as conditional to be eligible for the Transmission Protection Mechanism (TPI). Investors, however, have thus far shown only limited signs of agitation.

 

French political jitters and OATs issuance deluge

To complicate things further, France is facing a political gridlock which prevents the government to commence discussion on formalizing a concrete and credible fiscal consolidation plan. Macron has recently nominated Michel Barnier as the new French prime minister. Nonetheless, this candidature may be rapidly blocked in the parliament via a vote of no-confidence. Headlines have only worsened sentiments in recent days, with the French government indicating a likely fiscal slippage to 5.6% from the 5.1% originally budgeted. Regardless of the outcome of the parliamentary confidence vote, the new prime minister will face significant challenges to secure €16 billion in savings, as advanced by the current finance minister Le Marie. On the budget preparation, this needs to be submitted to the Assembly by October 1st. In a pre-emptive move, prime minister Attal has already sent directives to the ministries keeping total expenditures unchanged. Obviously, maintaining budget figures consistent with 2024 would entail quite a significant slippage. The French political saga will continue to populate headlines with the market’s risk aversion to French Obligations Assimilables du Tresor (OATs) at record highs.

 

From a technical standpoint, the issuance season has just kicked off in earnest. Despite the front loading witnessed in the first half of 2024, relative investor appetite for primary deals will remain under scrutiny. According to estimates, eurozone countries have achieved more than 75% of their 2024 funding objectives, with France expected to issue a whopping €25.3 billion net issuance in September only, out of a total of nearly €326 billion for the year. When analyzing French debt issuance relative to other EGBs, debt sustainability concerns and the ability of domestic investors to absorb this deluge of supply have increasingly contributed to the decoupling of OAT historical spread beta vs other EGB spreads. The IMF[1] has published annual figures on French debt ownership broken down by type of investors and in 2023 we have seen a record amount of buying from foreign investors while domestic non-bank demand has shown signs of weakening since 2022. A key question remains whether domestic institutional investors, who have historically shown high elasticity to the level of yields, will be able to cover any outflows from foreign investors when additional supply out of Quantitative Tightening (QT) flows is taken into consideration. This is particularly relevant in a context of likely repatriation flows by Japanese investors amid the tightening bias by the Bank of Japan (BOJ). In fact, recent weekly transaction data released by the Japanese Ministry of Finance indicates that Japanese investors have largely favored US Treasuries over EGBs as the FX hedge cost for US dollar asset purchase stands lower than that for euro assets (currently slower cutting cycle expected for the eurozone as opposed to the US).

Chart 1: Evolution of holdings of French central government securities by various investor types, % of the total. Source: IMF, Aegon Asset Management.

 

Italian fiscal slippage and borrowing needs

A neighboring country finding itself in similar fiscal strains is the one currently ruled by Giorgia Meloni. As for France, the third-largest eurozone country is grappling with two important overlapping deadlines: the medium-term fiscal consolidation adjustments by September 20th to the EC and the update of its fiscal plan (NADEF) by September 27th to its parliament. The latter document is a reiteration of what was outlined in April, addressing growth and public finances projections. These are based on fairly optimistic assumptions of keeping the current legislation scenario. The discontinuation of the widely criticized “Superbonus” housing tax credit weighing heavily on debt-to-GDP figures while propping up the Italian construction sector (up 60% since the implementation of the scheme back in 2022 according to ISTAT[2]) may add fuel to worries over a larger than expected growth revision.

 

Technical factors for Buoni del Tesoro Poliennali (BTPs) are concurrently less constructive than for other peripheral debt and the increase in the free float of BTPs could be historically high next year while the ECB is progressing unabated with its QT programme. This may cause borrowing indigestion concerns, particularly if the support of the retail sector (via BTPs Valore) loses steam amid lower expected rates and heightened competition from banks offering higher-yielding deposits.

 

The outlook for French and Italian finances remains unpleasantly grim and uncertainty will surely keep dominating headlines. Macroeconomic narrative, to a large extent dependent on US economic development and recession fears, may exert significant widening pressure on EGB spreads and relegate more country-specific news to the back seat. Whilst a structural long carry positioning has historically been able to provide additional return in a more stable environment, volatility has conversely penalized investors positioned in long carry trades. Considering the sharp moves seen in recent months, a nimbler asset allocation is more important now than ever.

[1] https://www.imf.org/external/datamapper/profile/FRA.

[2] https://esploradati.istat.it/databrowser/#/.

Disclosures

Author

Luca Ferramosca
Portfolio Manager

Luca Ferramosca, CFA, is a portfolio manager with a focus on sovereigns. Prior to his current role, he worked as an institutional sales analyst at Aegon AM. 

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