Italy Loses Goldman’s Favor as Slump Amplifies Debt

Investors are turning against Italy’s government bonds as the euro-area’s third-largest economy falls back into recession.

Some JPMorgan Asset Management funds moved out of 10-year Italian securities into Spanish debt, while Credit Agricole SA and ING Groep NV recommended trades to take advantage of Spain’s superior economic momentum. At Goldman Sachs Group Inc., economists downgraded their growth forecasts for Italy and bond strategists suggest a neutral position on the nation, which was the firm’s top pick of large, liquid sovereign markets for 2014.

“We have switched our exposure,” said David Tan, head of rates at JPMorgan Asset Management, which oversees $1.7 trillion. The shrinking economy “is a little warning signal out there. I’m no longer overweight 10-year” Italian bonds.

After returning 14 percent in the past year, Italy’s bonds are losing attractiveness with the economy unexpectedly contracting in the second quarter. Prime Minister Matteo Renzi has struggled to carry out structural reforms so the nation’s debt burden of almost $3 trillion slows its growth pace. Last week, Italian senators preliminarily approved a bill that will strip the chamber of many of its powers, in Renzi’s first institutional victory since he took power in February.

Government bonds across the euro area rallied this year as the European Central Bank introduced extraordinary monetary stimulus. The spread compression to German yields has narrowed to such an extent that investors have begun to discriminate more between Italian and Spanish bonds, seeking gains from Spain’s relative outperformance.

Tan’s Funds

Tan said his firm has “switched some Italian exposure into Spain, in response to some deterioration´´ in the larger economy relative to the smaller one. Tan’s funds moved their allocations of 10-year Italian bonds to securities maturing in two and five years, or into 10-year Spanish debt, he said in an interview at his office in London on Aug. 6.

Italy’s gross domestic product fell 0.2 percent in the three months through June from the first quarter, while government debt rose to a record 2.17 trillion euros ($2.91 trillion) in June.

Goldman Sachs forecasts Italy’s economy to contract 0.1 percent this year and expand 0.9 percent in 2015, down from an earlier predication of 0.6 percent and 1 percent growth, respectively. Spain’s economy will grow 1.2 percent this year, up from an earlier forecast of 0.4 percent, Goldman forecasts.

Italian ‘‘growth has disappointed and been much lower than we expected,” Silvia Ardagna, a London-based senior economist and rates strategist at Goldman Sachs, said by phone on Aug. 11. “The reform process is showing to be slower than we were anticipating. The growth picture in Spain has improved relative to Italy’s over the course of the year.”

Goldman ‘Neutral’

Goldman Sachs is recommending investors turn neutral on Italy and the rest of the euro-area periphery. It doesn’t expect spreads to tighten much further, though the coupon offered on the higher-yielding bonds is still attractive, Ardagna said.

Italian government bonds returned 0.5 percent through Aug. 14 since the GDP data was released on Aug. 6, according to Bank of America Merrill Lynch Indexes. By comparison, Spanish securities returned 1 percent in the same period, the indexes show.

Credit Agricole extended its target for holding Spanish 15-year bonds versus 10-year Italian securities to 55 basis points from 65 basis points last week. This trade will benefit if Spain continues to outperform, Peter Chatwell, a fixed-income strategist, said on Aug. 12.

Economic Divergence

“There has been significant economic divergence between the two countries, GDP being the highest-profile example of this,” he said.

ING advised investors have a long position on the 4.85 percent Spanish bond maturing in October 2020 versus a short position in 4 percent Italian bonds due in September 2020. The Spanish bond currently yields 17 basis points less than the Italian. ING recommends a target of minus 30 basis points and exiting the trade at minus 8 basis points, strategist Alessandro Giansanti in Amsterdam wrote in an Aug. 8 note.

Spain’s economy expanded 0.6 percent in the three months through June, the fourth consecutive quarter of growth. By comparison the euro-area average showed no growth, in a report yesterday. Prime Minister Mariano Rajoy has implemented the deepest austerity measures in the Spain’s democratic history since coming to power in 2011.

Carmignac Maintains

Even with the economic recession in Italy, some investors are putting their faith in Renzi and his commitment to reform.

Carmignac Gestion SA, which oversees 49.9 billion euros in assets, has maintained its positions in Italy and Spain recently, keeping a greater weighting toward Italy.

“Italy is on the cusp of important reforms that will work through in the economy and that they will redouble their efforts because of the very poor growth data which is lagging,” Sandra Crowl, a member of its investment committee, said by phone on Aug. 13. “We are confident in the Renzi government that this is the best chance that Italy has had in decades to reform.”

The extra yield investors demand to hold Italian 10-year debt over similar-maturity Spanish bonds was at 17 basis points as of 8:37 a.m. in London. The spread widened to 25 basis points on Aug. 8, the most since February 2012. Spanish bonds yielded more than Italy’s as recently as March. Ten-year Italian yields were at 2.63 percent, and the rate on Spanish bonds was at 2.46 percent.

Reform Momentum

“The economic momentum and reform momentum is without a doubt with Spain,” according to Stephen Cohen, chief investment strategist for international fixed income at BlackRock Inc., the world’s biggest money manager, with more than $4 trillion of assets under management.

While BlackRock has had a neutral position on euro-area peripheral bonds, Cohen said on Aug. 13 that 10-year bonds will see more spread volatility as investors consider the longer-term fundamentals of Spain and Italy.

“Spain is proving so far to be a good example of the positive impact of reform,” he said. “With Italy there are still a lot of question marks around Renzi. Reforming Italy is a big challenge and he is probably the best chance of the possibilities that are out there.”

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