How to Play Italy Versus Spain With Their Bonds

 | Sep 12, 2017 | 8:00 AM EDT
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In May last year, I wrote an optimistic article about Italy for which I received a lot of criticism. Italy is on the brink of collapse, the critics essentially said at the time, and there is nothing that can save it. But, while things did not turn out exactly as I had anticipated, there are signs that Italy finally is turning the corner.

Industrial production has increased by healthy percentages recently, advancing by 5.2% in June year on year and by 4.4% in July.

Economic confidence hit its highest level in almost a decade. The index of economic sentiment reached 107 in August, which is the highest level since November 2007, when the global financial crisis was starting and the eurozone had not yet been affected.

The Italian economy has been growing for 10 straight quarters, although its recovery still lags that of other eurozone countries. In the second quarter, GDP expanded by 1.5% year on year, driven by investment, exports (despite the stronger euro) and household consumption.

Unemployment has been coming down very gradually, but it is still high and it is the main problem for the eurozone's third-largest economy. It was 11.3% in July compared with 11.5% in July last year, 11.7% in July 2015 and 12.6% in July 2014.

For young Italians, joblessness is much worse, even though it is falling faster than general joblessness. Unemployment among the 15- to 24-year-olds was 35.5% in July this year, down from 38.2% in July 2016 and from 39% in July 2015.

These gradual improvements have been reflected in the markets. The iShares MSCI Italy Capped ETF (EWI) is up 43.6% in a year. It has risen by 27.6% since May last year.

To be sure, the country is not free of political tension, which still threatens the unity of the eurozone. The anti-establishment 5-Star movement, which more than two years ago gathered the number of signatures needed to call a referendum on leaving the euro, has put the idea of that referendum on the back burner for now. Instead, it has been speaking about introducing a parallel currency in Italy, which initially only would be used by people to pay their taxes.

Such talk sits uneasily with officials in the eurozone, who see it as a step toward breaking the unity of the single currency. However, for now the political situation seems contained, at least until elections, which are due to take place no later than May 20, 2018.

Politics seem more tense in Spain, where the constitutional court last week suspended a vote by the Catalan parliament to hold a referendum on Catalonia's independence from Spain on Oct. 1. The court is examining whether the Catalan referendum breaches the constitution, but pro-independence Catalan leaders said the vote would go ahead as planned.

Strategists at Societe Generale see this contrast between the eurozone's third- and fourth-largest economies as a good trading opportunity for their sovereign debt. They recommend going long Italian 10-year government bonds, or BTPs, versus short 10-year Spanish government bonds, or Bonos.

The spread between the yields of these two bonds has narrowed quite sharply, from 64.30 basis points on Aug. 22 to 39.7 on Sept. 11, according to FactSet data. Bond yields move inversely to prices. Investors willing to try this trade should be aware that the spread is now below the Societe Generale strategists' entry target of 47 basis points.

Societe Generale fixed-income strategist Marc-Henri Thoumin told Real Money in a brief telephone chat that he still was recommending the trade, which he had devised to run for a period of a few weeks. His target for the BTP/Bonos spread is 34 basis points, with a stop at 53 basis points.

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