Turning Increasingly Bearish On Periphery Debt

We believe investor concerns surrounding the fallout from bankrupt Portuguese lender Banco Espirito Santo (BES) could act as the 'trigger' for a turning point in sentiment towards periphery sovereign debt markets. Portugal's 10-year bond yield has risen 30 basis points (bps) in August, and its main equity index is down almost 25% since June, due to worries over how a BES bailout would affect government finances ( see 'Threat Of Contingent Liabilities Rising', August 7).

Spanish and Italian bond yields have risen as well ( see chart above), and we believe fears over Portugal's banking sector will cast further doubts on the sustainably of Spanish and Italian debt loads given their troubled banking sectors' similar exposure to the banks/sovereign nexus. In turn, rising borrowing costs could put the brakes on the already stuttering eurozone recovery, by demanding further austerity from periphery states ( see 'Lack Of Reform Points To Bigger Role For ECB', July 18).

Italian yields look particularly precarious. Italy's quarterly real GDP growth rate contracted 0.2% in Q214, its public debt load is the second largest in the EU (over 130% of GDP) and the new administration of Matteo Renzi has been pushing for a relaxation of EU imposed austerity measures. A comparative lack of progress implementing structural and fiscal reforms in Italy has contributed to Spanish 10-year yields moving 28bps below Italian equivaelents, from a 100bps premium two years ago ( see chart below), and a further move in Spain's favour now looks likely.

Portugal Jitters The Trigger For A Yield Blowout? 
Eurozone - 2023 Spain, Italy and Portugal Government Bonds, % Yield

We believe investor concerns surrounding the fallout from bankrupt Portuguese lender Banco Espirito Santo (BES) could act as the 'trigger' for a turning point in sentiment towards periphery sovereign debt markets. Portugal's 10-year bond yield has risen 30 basis points (bps) in August, and its main equity index is down almost 25% since June, due to worries over how a BES bailout would affect government finances ( see 'Threat Of Contingent Liabilities Rising', August 7).

Portugal Jitters The Trigger For A Yield Blowout? 
Eurozone - 2023 Spain, Italy and Portugal Government Bonds, % Yield

Spanish and Italian bond yields have risen as well ( see chart above), and we believe fears over Portugal's banking sector will cast further doubts on the sustainably of Spanish and Italian debt loads given their troubled banking sectors' similar exposure to the banks/sovereign nexus. In turn, rising borrowing costs could put the brakes on the already stuttering eurozone recovery, by demanding further austerity from periphery states ( see 'Lack Of Reform Points To Bigger Role For ECB', July 18).

Investors Worried About BES Losses
Portugal - PSI20 Equity Index

Italian yields look particularly precarious. Italy's quarterly real GDP growth rate contracted 0.2% in Q214, its public debt load is the second largest in the EU (over 130% of GDP) and the new administration of Matteo Renzi has been pushing for a relaxation of EU imposed austerity measures. A comparative lack of progress implementing structural and fiscal reforms in Italy has contributed to Spanish 10-year yields moving 28bps below Italian equivaelents, from a 100bps premium two years ago ( see chart below), and a further move in Spain's favour now looks likely.

Spain Has Made More Progress On Rebalancing
Eurozone - Spread Of Spanish Over Italian 2023 Government Bond Yields, Basis Points

Despite our belief that periphery fixed income is overvalued using traditional valuation metrics, we nevertheless are wary of entering a bearish periphery sovereign debt view in our asset class strategy table for the time being. The ECB's commitment to unlimited bond buying via its Outright Monetary Transactions programme remains in place, while expectations that some form of quantitative easing will eventually be implemented continue to mount. With the ECB mitigating default risk, low inflation in the periphery has bolstered the real return on government securities. Furthermore, banking sector demand for sovereign debt remains strong in light of weak credit growth, keeping downside pressure on yields.

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Related sectors of this article: Economy, Finance, Fixed Income, Economic Activity, Investment Climate, Fiscal Policy
Geography: Spain, Italy, Portugal
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