Becoming more upbeat about the euro periphery

Peripheral countries started the year on a strong footing, thanks to pent-up demand from the pandemic, a solid labour market and fiscal support. While the Italian and Spanish economies slowed in Q2, their overall performance over the first half of the year was positive. 

Looking ahead, we expect positive, albeit slowing, growth in H2 in Italy and Spain. Robust wage growth, slowing inflation and a resilient labour market will support household consumption, but tighter monetary policy will weigh on investment. The Next Generation EU fund (NGEU) will continue to support economic activity in peripheral euro area countries, even if implementation challenges have become apparent (especially in Italy).

In line with economic resilience, Italian and Spanish sovereign bond markets have outperformed their core euro area peers year-to-date. In particular, the positive returns from Italian and Spanish bonds is in stark contrast with the negative performance their German counterparts. Their outperformance is due both to tighter spreads versus the Bund and more attractive carry thanks to higher yields.

We would expect 10-year Italian and Spanish sovereign bond spreads against the Bund to have widened only slightly from their current levels at year’s end. Attractive carry, and relatively resilient economic growth, along with limited risks of budgetary expansion (particularly in Spain, given political stalemate) are all factors that explain why we are more constructive on peripheral euro area bonds than before. This environment could continue to make euro periphery sovereign bonds resilient to restrictive monetary policy. 

Moreover, even if quantitative tightening is accelerating, the likelihood that the European Central Bank is near the end of its hiking cycle (we expect the deposit rate to reach a terminal rate of 4% in September) could limit upward pressure on euro sovereign bond yields, in our view. For this reason, we expect 10-year Italian and Spanish sovereign bond yields to stay broadly stable until year’s end, thereby continuing to offer an attractive carry.