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Blog Posts — October 10, 2018

Doom Loop Reloaded? – Stress testing Italian contagion risk

by Christoph Schon, CFA, CIPM

In an eerie reminder of the European debt crisis of 2010-2012, the Italian government has seen its financing rates rise dramatically over the past couple of months. The risk premium of its 10-year benchmark over the same-maturity German Bund surged from 1.20% in late April to just under 3%—its highest level in over 5 years—after the budget announcement at the end of September. Over the same period, the euro declined by almost 7% against the US dollar.

The latest surge in Rome’s borrowing costs was triggered by the populist government’s decision to aim for a budget deficit of 2.4% of gross domestic product (GDP) in 2019. Though this is still well below the 3% ceiling prescribed by the European Union, it is 3 times the 0.8% targeted by the previous administration and above a rate that would be compatible with debt reduction.

Limited contagion

Up to this point, contagion to other peripheral issuers has been fairly limited. The spreads of Spanish and Portuguese government bonds above their German equivalents are so far just 40 basis points wider. Even the risk premium on Greek debt has only risen by 60 basis points. Portugal (124%) and Greece (180%) are the only other two countries in the European Union with a similar or higher debt-to-GDP ratio than Italy (132%), while Spain’s debt position is much more favorable at 97% of national output.

The ‘doom loop’

There is, however, a growing concern that a further devaluation of Italian government debt could finally spill over to other countries in the European periphery. The so-called ‘doom loop’ during the Eurozone debt crisis provides an example of how this might unfold. Financial institutions tend to hold a large amount of sovereign debt—often from their home country—on their balance sheets. Many Italian banks are struggling already. Any further deterioration in their asset base could lead them to once again seek a government bailout, which, in turn, would further weaken the fiscal stability of the sovereign. This has already started to be reflected in higher credit default swap premia for Italian banks.

How much more are spreads going to widen?

So how can we stress test this? First, we need to choose the variable(s) we intend to shock and by how much. At the height of the sovereign debt crisis in November 2011, Italian 10-year BTPs yielded 7.10%—or 520 basis points over the same-maturity German Bund. We therefore think it would be reasonable to apply a 200-basis point widening on top of the current spread level of around 300 basis points.

Suitable historical precedents

The second prerequisite for the stress test is to find a suitable historical time period to derive the movements of the remaining pricing factors for other asset classes. One obvious choice would be the actual debt crisis, which would encompass both significant spread-widening and a certain amount of contagion. Another interesting test period would be the current correlation environment, which has also been characterized by political uncertainty in Europe.

The table below shows results from two sample stress tests for a 200-basis point rise in the BTP-Bund spread, which we applied to a global, euro-denominated, multi-asset class portfolio in our Axioma Risk™ platform. The first one (“Eurozone Debt Crisis”) uses weekly correlations from 2011-2012, while the second one (“Current Correlations”) is based on daily returns over the past 3 months.

Not too surprisingly, Italian assets are hit hardest in both scenarios, with both stock and bond markets each losing around 10% on average. The results also confirm our earlier observation that there seems to be limited contagion under current correlations. While Spanish and Portuguese sovereign bonds exhibit similar drawdowns to their Italian peers in the debt crisis scenario, losses are a lot more contained in the current environment. Any spread widening on lower-rated corporate debt also seems to be less severe in the latter case.

Pound decoupled due to Brexit uncertainty

The same applies to the local stock markets. As expected, core sovereigns are the main beneficiaries of the ‘flight-to-quality’ behavior in both cases, as is the Japanese yen. The British pound, on the other hand, shows a less consistent performance. While it managed to profit in the first case, the recent, Brexit-induced decoupling from other markets led to an almost zero-correlation with the rest of the portfolio.

Commodity prices driven by OPEC action and inflation concerns

The two commodities also seemed to show an inconsistent reaction across the two environments. In the crisis scenario, we see the expected movements of the oil price going down alongside the stock market and gold benefitting from its safe-haven status. However, causalities seem to be reversed in the current environment. We have noted several times in our regular commentary and webinars that oil has recently been driven more by OPEC action and geo-political considerations than the performance of the overall economy. The losses of the gold holding can probably be attributed to the consumer price growth concerns that have been creeping up over the past few weeks. When inflation expectations rise, this is usually bad for fixed-income instruments, but good for the precious metal, which is considered a good hedge against price-level increases. This implies a negative correlation between the gold price and the bond market, which is reflected in the negative return of the gold holding, while core sovereigns increase in value.