While investors may overlook S&P’s decision to downgrade France’s credit rating late Friday, the development is a reminder of the changing economic landscape across Europe. Compared to the situation before the pandemic, growth in peripheral countries (such as Spain and Greece) is now outpacing that in core countries (such as France and Germany). Beyond credit ratings, sovereign bond yields also tell the story, with Greek 10-year bond yields lower than Italian and Portuguese 10-year bond yields lower than Spanish.
This apparent shift could also lead to some core countries (such as France and Belgium) being included in the European Commission’s Excessive Deficit Procedure this year. However, the EDP provides countries with greater discretion in addressing their debt levels.
Nevertheless, Italy is once again facing debt sustainability issues due to growing pandemic-related tax credits (i.e., “super bonuses”), which are once again putting Italy’s debt burden on an upward trajectory. In addition, the ECB’s pandemic purchase program, which has been a source of demand for Italian debt, is due to end at the end of this year. As a result, the market will need to absorb more Italian bonds, with the country’s cash financing needs averaging around $150 billion over the next few years, compared to $50 billion before the pandemic.
From a broad market perspective, while we have covered the strategic rationale for fixed income allocations at various points, our tactical view is shifting from slightly bearish to more neutral due to a number of factors. Volatility in the first half of the year continues to unexpectedly push interest rates higher (the US 10-year Treasury yield hit 4.62% last week), creating buying opportunities for investors to position for possible rate cuts. Ebbing risk sentiment amid geopolitical events, political developments and/or ongoing conflicts in Ukraine and the Middle East could also lead to lower yields.
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