Italian and Spanish sovereign bonds : 2024 outlook

Growth in euro zone periphery countries has been relatively resilient this year thanks to strong construction activity in Italy and a pickup in tourism, especially in Spain. We expect growth to be subdued in early 2024 before picking up somewhat.

In Italy, weak global demand, the impact of high interest rates and the gradual phas-ing out of tax credits (the so-called ‘Superbonus’) are the main risks. At the same time, rising real household income should still support economic activity.

Fiscal policy will remain a key focus next year amid risks of fiscal slippage, particu-larly in Italy. Even if we expect the EU Commission to use some discretion, both coun-tries are at risk of an Excessive Deficit Procedure (EDP) in spring 2024. A lot will also depend on whether we have a deal on EU fiscal rules or not.

Euro periphery bonds have put in a resilient market performance. Ten-year Italian and Spanish sovereign bonds have outperformed their French and German counter-parts, posting a positive total return performance year-to-date of 12.1% and 7.9%, respectively, on 15 December (in euros).

With no major improvements in economic outlook or public finances in sight, we expect 10-year Italian and Spanish sovereign spreads versus the Bund to be range bound next year (between 150 bps and 200 bps in Italy and between 80 bps and 110 bps in Spain). Decent yields of 3.7% for 10-year Italian government bonds and 3.0% for their Spanish equivalents (on 15 December) mean that we have raised our stance on periphery sovereign bonds from underweight to neutral.

With the PEPP decision out of the way, the focus will be the (inflation) data in the next couple of months to determine the timing of the first rate cut. Our baseline scenario has been for the ECB to start cutting rates in June, with a risk of an earlier move in April, but a lot will also depend on the Fed, whether the ECB likes it or not.

We remain overweight core euro sovereign bonds as core countries have more fiscal space than either Italy or Spain where risks to medium-term fiscal sustainability remain. Market participants are likely to be unforgiving should we see fiscal slippage or should governments in these countries fail to implement much-needed structural reforms.