Citi’s “What If?” Scenarios: Part 2

Yesterday we published the first set of 7 “What If” scenarios that didn’t make it into the Citi Credit team’s (already rather gloomy) year-ahead forecast. Because while Citi’s “base case” was clearly bearish (our summary can be found here), what was left unsaid was even more unsettling, if not troubling. As the bank’s credit team wrote “what about the outcomes that didn’t quite make it into our base case? The scenarios that aren’t central, but which aren’t entirely implausible either – both bullish and bearish.” Citi then listed the following 7 scenarios in the first part of its quasi-forecast:

A full discussion of the above scenarios was posted yesterday.

Today, we follow up with part 2, or the second set of 7 hypothetical questions for 2018, which shifts away from economics and finance, and focuses on politics and Europe. As Citi’s credit team writes “you tend to worry less about your leaky roof when the sun is shining. And at the moment the cyclical economic upturn is beaming across Europe. Yet there are clouds which might conceivably hold moisture – or as our economists have put it: political risk is not dead in Europe.”

So to avoid a leaky roof turning into a flood, Citi once again set out some of the economic and fundamental scenarios for 2018 that aren’t in the bank’s base case, but which remain reasonably plausible nonetheless; specifically, Citi looks at the list of “potential political dark horses for next year.” These include the following “what ifs”:

While Citi concedes that there are many others it could have included, like Middle-East tensions, North Korea tensions, global trade relations, US mid-term elections, escalation in the South China Sea or relations between Russia and the West, these will have to wait for another time. Until then, here is a breakdown of the political “What Ifs” that would keep Citi at night if they were allowed to be part of the bank’s official base case.

1. the market falls out of “amore” with BTPs?

Markets seem largely to have grown comfortable with the idea of an unusually large number of different political constellations that are feasible after the next Italian general election. Legally, they must take place by May, but national newspapers have reported that a deal has been made to hold them on March 4.

Our economists see a center-right victory as marginally the most likely outcome, but longer-term, big question marks remain over which individual party will dominate within the bloc and the true depth of ostensible EU-scepticism. A grand coalition over the middle also remains a possibility, albeit a fading one. Either would probably be seen as somewhat positive by markets in the immediate aftermath. However, with the M5S still gaining in many polls at the expense of a struggling PD, their involvement in a future coalition of the left remains a reasonable probability. Although M5S has certainly shifted its stance on the EU significantly, with its candidate for PM declaring he wants to stay in the EU and toning down his party’s opposition to the euro, other of their desired reforms would likely be seen as negative by the market. A less likely coalition between M5S and a party on the right, like Lega Nord, could potentially be more confrontational and even less market-friendly.

While the moderation instances and the cyclical upturn in Italy have diminished the probability of more extreme outcomes, demand for BTPs could still prove fickle amid the uncertainty and a reduction in ECB purchases.

Indeed, you could argue that private investors fell out of love with BTPs quite some time ago. As illustrated in Figure 1, just about every other major investor type has become a net seller (to the ECB) or a non-buyer of BTPs over the last couple of years. To change that behavior, we think it remains pretty likely that there will need to be an adjustment in prices. As our rates strategists have pointed out, the ECB could counteract this through an “Italian Operation Twist” (lengthening the maturity of their BTP holdings), but such a response might not come immediately, given the ECB’s reluctance to favour individual countries, unless associated with the conditionality that comes with an economic adjustment programme.