European High Yield Faces Two-Headed Hydra From Italy, EM FX

Over the past several months, Italian budget risk and EM FX woes have taken turns denting risk sentiment.

The old “If it’s not one thing, it’s another” refrain very often takes the form of “If it’s not turmoil in EM FX, it’s a bloodbath in Italian assets“.

But Italy jitters and EM woes aren’t mutually exclusive. There’s a nexus there. UniCredit, for instance, controls 41% of Yapi Kredi, and that exposure was brought to the public’s attention in August as the Turkish lira collapsed.

(Goldman)

In addition to the direct exposure, what’s happening in some developing economies serves to amplify concerns over Italy as the turmoil in certain EM locales is a stark reminder of how quickly the market can lose confidence in deteriorating economic fundamentals.

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Contagion: Lira Collapse Spreads To Europe

There’s Only One Kind Of Umbrella For This Perfect Storm

Well, as you may be aware, Italy is heavily represented in Euro HY. We’ve been over this on countless occasions previously. In light of the ECB winding down CSPP and considering the recent budget drama in Rome, it’s worth asking whether the potential exists for a kind of “double whammy” scenario where the relative weighting of Italian credits at the index level ends up causing problems at a time when spreads are set to lose the technical tailwind from CSPP.

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Pulling The Punchbowl When The Espresso Is Hot And The Economy Is Cooling

When you throw in the EM nexus, this gets even more dicey (and even more convoluted).

“We think investors should be cognizant of the demand-sapping effect of EM volatility on European high yield”, BofAML writes, in a note dated October 5, on the way to highlighting the following set of charts.

(BofAML)

That visual in the right pane is pretty astonishing. The correlation of Euro HY fund flows with EM FX is near 90%.

This comes at a delicate time. Rising yields on USD “cash” (i.e., short-term USD fixed income) are sapping demand for speculative grade European credit (and for risk assets more generally). Meanwhile, the ECB is preparing to turn off the liquidity spigot and when the price insensitive Draghi bid dries up at the top of the quality ladder, you’re going to see the dynamics that drove everyone out the risk curve reverse. That means high yield spreads are likely to start reflecting sector- and credit-specific risk again as opposed to being priced to perfection on the back of the global hunt for yield.

“Year-to-date, Euro-domiciled HY funds have experienced a painful $33bn of outflows (12% of assets)”, BofAML writes, in the same note mentioned above, adding that “the inflows into European HY witnessed in the ‘ECB era’ have now been withdrawn.”

(BofAML)

Given all of the above, one is certainly left to wonder what fate will befall European HY in an environment where Italian credits come under pressure thanks to contagion from the sovereign and EM FX continues to labor beneath rising U.S. yields and dollar strength.

There are so many self-referential dynamics in play there that it will make your head spin. Italian names make up 17% of European HY, European HY fund flows are highly correlated to EM FX and EM FX is under pressure from the very same rising dollar and higher U.S. yields that are serving to sap demand from the very same European HY funds.

To top it all off, Italian assets are caught up in an ongoing and increasingly contentious budget battle between Italy’s populists and Brussels.

Think on all of that.