Citi: Equities and Bond Impacts from ECB Decisions and Political Crisis in Italy – Periphery at Risk

Her Eleftherias Kourtalis

The ECB is set to raise interest rates for the first time in more than a decade while unveiling its new anti-fragmentation tool. However, the market has already marked a strong de-rating in anticipation of these moves, as noted by Citigroup. “We are less concerned about the further decline in valuations and more about the impact on corporate profitability and rising recession risks,” he stressed, adding that he believed the market was discounting a slowdown in the economy, but not a recession. In this context, the US bank is watching the market for any signs of financial stress through widening Italian bond spreads, which could put pressure on the region and especially on the region’s and Italy’s banks.

Historically, as Citi points out, the equity market has “digested” ECB rate hikes relatively mildly except where there have been clear policy mistakes. The ECB is launching a widely anticipated policy tightening in coordination with other major central banks. The equity market is already sharply undervalued in anticipation of interest rate moves, so the risk to equities going forward is mainly about the impact of interest rate hikes on listed companies’ earnings per share (EPS) and increasing the likelihood of a recession in the economy.

“We continue to monitor the bond market for any signs of risk as the focus in bond markets has shifted to the widening of Italian spreads and how the ECB will react. Investors have been waiting for the ECB to introduce the new anti-fragmentation tool after the sharp widening Italian bond spreads last month and the return of Italian political risks have since increased risks,” the US bank said.

However, Citi economists believe that the ECB will proceed with an anti-runaway spread tool rather than an anti-fragmentation tool. They expect it to be generous, but have high trigger limits. The board will likely focus on the volatility of spreads across countries rather than their level.

Citi’s interest rate strategists therefore believe that Italy’s spreads will widen further, while the political landscape in the country also shifts risks to higher spreads, as even the most favorable outcome to Italy’s political impasse would leave spreads largely unchanged. Risk scenarios such as early elections could add up to 70 basis points to the 10-year Italian bond spread, pushing it above 300 bps.

Impact on the market

The performance of long-dated bonds tends to matter more than short-dated bonds to stock market performance, Citi points out. The ECB’s new tool should help calm bond volatility. However, any worsening of political unrest in Italy – and the resulting widening of spreads – could put pressure on regional markets and banks in particular.

So far this year, markets have largely diversified between regional (relative underperformers) and European (relatively outperformers) banks. This could mean that markets view the Italian spread widening as a specific risk to Italy, with less systemic impact than in the past. “This is why we continue to favor UK/Swiss banks, which will see their profitability boosted by higher interest rates,” notes Citi.

Finally, on the macroeconomic front, Citi notes that global economic activity has slowed significantly this year, and its economists now forecast mild recessions in both the US and the eurozone over the next 12-18 months. In Europe in particular, the recent jump in gas/electricity prices was “the last straw”, as the resulting damage to household/business confidence will cause a significant reduction in consumption and investment. Eurozone GDP is expected to grow by +2.5% this year followed by growth of just +0.8% in 2023, with Germany bearing the brunt of the latest downgrades (hopes for a manufacturing recovery have effectively been shelved for the end of 2023).

Furthermore, a complete cut-off in Russian gas supplies could reduce Eurozone GDP by more than 1%. This would imply a 10% contraction in European EPS over the next 12 months, while recession risks materializing could push share prices to a further 10% plunge from current levels.