Market story: Italy on the verge of rating downgrade by Moody's? 📊

The last few days might indicate that the market is calm. However, this is only an appearance, as it is possible that a jolt is in store. All because of the update of the credit rating of the G7 country. Do we have anything to fear?

Decision on Friday

The update of Italy's credit rating is expected to take place on Friday. It is worth mentioning that Moody's decided to change the rating outlook to negative from stable for Italy last August. More importantly, Italy's credit rating level is on the verge of investment grade and "junk" grade, or BAA3. At this point, a downgrade scenario does not appear to be the baseline scenario - that's not really what the market is pricing in. The yield spread is 170 basis points at this point, although until recently the spread was close to 200 bps. What's more, the spread is much lower than it was during the downgrade of the credit rating outlook in the summer of 2022, when the 'controversial' Giorgia Meloni took over the Italian government.

The yield spread is far from the highs of last 'Meloni' year. Moreover, the spread is a far cry from the levels of the 2011-2013 Eurozone debt market crisis. The market doesn't seem as concerned about the possible consequences. Source: Bloomberg Finance LP, XTB

A repeat of 2011?

Commentators point out that a downgrade by Moody's for Italy could lead to a similar situation as in 2010, when S&P decided to downgrade the credit rating to junk status for Greece, which was the beginning of the eurozone debt market crisis. Moreover, the average time to change the outlook or rating since the previous decision is usually 1 year. It is not out of the question that Moody's may decide to raise the rating outlook to stable, which could lower the spread and lead to another positive wave in the Italian stock market.

Moody's indicated more than a year ago that Italy's problems are structural reforms and the energy market situation. However, Meloni points out that Italy has made improvements on both of these issues. Of course, the IMF's latest forecasts indicate that Italy will take longer to get out of excessive debt - the debt-to-GDP level is expected to be above 140% all the time until 2028, although at the same time it is expected to shrink moderately. It's also worth mentioning that countries such as France, the UK and also Japan have debt-to-GDP levels clearly above 100%, yet their credit rating levels are much higher.

Moreover, it is important to remember that Moody's has the lowest credit rating level among the big three rating companies. A downgrade by Moody's may not necessarily mean an attempt to sell Italian debt by funds that have in their policies investments only in investment grade debt. In addition, the ECB unveiled a tool last year that would counter excessive spread widening. To date, such a tool has not been used. It is worth mentioning that Italy will not go bankrupt at all immediately when the downgrade occurs, nor will it leave the eurozone or the European Union. It is unlikely that anyone expects that such a situation could occur.

In addition to this, it is worth mentioning that of course it would be a historical situation, just like a rating downgrade in the US, but at the same time the impact could be limited, looking also at the hedging tools. In the case of a rating cut, market moves would certainly big at first. But is there a chance of a move in the other direction, and what do financial markets make of it?

Italian stocks rally

The FTSE MIB index has gained nearly 25% this year, more than the German DAX or the US S&P 500. On the other hand, the blue-chip index contains the largest financial companies that have benefited from high interest rates. Looking at smaller stocks, there we don't see such euphoria, which would give smaller companies, primarily financials, a chance to close this gap. Goldman Sachs itself estimates that a 10bp increase in the spread could lead to a 2% sell-off in banks. With strong gains by large banks like UniCredit, if the yield spread continues to fall, smaller companies operating in the financial sector are worth looking at.
The FTSE MIB has had a very strong rise this year, although from a long-term perspective, these stocks are cheaper than the entire set of global equities. On the other hand, we also have the rather weak sentiments on smaller companies. Will they be able to adjust to the large FTSE MIB index if the situation in Italy improves?