Don’t Judge a Country by Its Credit Rating, Italian Edition – Fisher Investments

Italy shows why credit ratings are a distraction.

In a widely watched move last week, credit ratings agency Moody’s raised its outlook for Italy to “stable” from “negative,” relieving the worries of many. Supposedly, this removes the threat—a “sword of Damocles” even—of the agency downgrading Italy to junk.^[i] But in our view, all the hullabaloo here was overdone. While ratings agency pronouncements may swing sentiment in the short term, the labeling doesn’t change a country’s fundamental ability to meet its debt obligations. Ultimately, that is what drives market moves longer term. And raters’ opinions tend to follow markets more than lead them, which this latest non-move illustrates well.

Judging by the headlines, you would think markets were on tenterhooks leading up to the proclamation. You see, in August 2022—following former Italian Prime Minister (and ECB President) Mario Draghi’s July resignation—Moody’s placed the country on negative credit watch, fearing the new government would backslide on the technocratic government’s structural reform program. The next month, populist Brothers of Italy leader Giorgia Meloni led her party to power in a government coalition, seemingly cementing fears they would blow out deficits, increasing default risk. And her recent budget plan, which boosts deficits beyond EU limits, only compounded chatter ahead of Moody’s scheduled review.

Italian 10-year interest rates did climb during much of September and October. The difference between Italy’s 10-year yield and Germany’s—the yield spread, a measure of perceived credit risk—widened. Many feared an even larger jump if a downgrade to junk actually came. So Moody’s non-change last Friday seemed to suggest Italy’s moment of danger had passed. Italy would remain at Baa3—the rater’s lowest investment-grade rung—with the release proclaiming: “Medium-term cyclical economic prospects continue to be supported by the implementation of Italy’s National Recovery and Resilience Plan, and risks to energy supplies have abated.”^[ii] And the outlook shift to stable implies a downgrade isn’t as imminent as a year ago. Whew!

But markets tell different story. As Exhibit 1 shows, the yield spread’s latest rise never put it near recent highs, sitting well below October 2022 levels. This may reflect familiarity with Meloni’s government—like how initial discomfort with Italian populists governing in 2018 – 2019 faded amid gridlock. Despite the recent budget pushing deficits higher, her coalition hasn’t pursued the massive tax cuts or spending programs many feared. Partly because, as coalition governments are wont, the Brothers of Italy’s partners couldn’t agree on them. But spreads also seem to have narrowed as mounting recession fears last year dissipated (akin to post-lockdown Italy in 2020). This was in keeping with the rest of Europe. Despite 2022’s fuel price surge, recession didn’t ensue. In any case, markets moved ahead of Moody’s views.

Exhibit 1: A Short History of Italian Credit

Source: FactSet, as of 11/24/2023.

So while yield spreads are susceptible to sentiment, Moody’s mood swings seem to matter much less. Another way to see this: Moody’s has rated Italy Baa3 since October 2018. The actual downgrade then came well after spreads jumped. This is the norm. During the eurozone’s debt crisis, ratings changes almost always followed spreads blowing out amid major news. Greece’s 10-year yield spread against Germany’s ballooned from under 1 percentage point to over 6 points before S&P Global downgraded Greek debt to junk in April 2010.^[iii] On the flipside, spreads also narrowed to reflect Greece’s improved creditworthiness—and return to budget surpluses this year—long before the ratings agency’s decision last month to promote Greece back to investment grade.

At the end of day, investors care far more about issuers’ debt service ability than ratings—which Exhibit 2 shows Italy clearly has. Although Italy’s interest payments as a share of its tax revenues have grown the last couple years, through Q2—the latest data available—its debt service burden stands at just 16.3%, almost a third of its 1990s’ peaks. The nation has also pushed out average maturities from just over 3 years in the early 1990s to over 7 years now, according to the Italian Treasury. That helps mitigate near-term interest rates swings’ effects. If Italy didn’t default then, we have a hard time seeing why it would be more prone to now. It is nice that Moody’s seemingly agrees to an extent, but that isn’t necessary.

Exhibit 2: Italian Debt Service Much Improved From Three Decades Ago

Source: FactSet, as of 11/24/2023.