Italy, Spain Will Mean More 'Carnage': Fund Manager

As euro zone finance ministers meet to discuss the latest plan on the table aimed at solving the Greek debt crisis, one fund manager is warning that Italy and Spain will be downgraded, raising the possibility of "carnage" for global markets.

“Italy was until recently deemed by the market (not by us) to be the ‘safe’ peripheral country, and a lot of international investors have been overweight Italy versus benchmarks as a proxy against zero holdings in Portugal, Ireland, Greece and Spain,” said Mike Riddell, a fund Manager at M&G in London in a research note.

With those bullish on Italy focusing on low private debt or the fact that Italy is too big to fail, Riddell believes the bond vigilantes have the euro zone’s third biggest economy in their sights, and "that is basically all that matters." “The Italy bears argue that Italy may be seen as too big to fail, but that doesn’t mean that it won’t, it’s too big to bail out.

Or Italy’s banks are seeing a slow but steady deterioration in asset quality. Or the deteriorating political situation.

The bears’ main worry is how Italy can prevent its high public debt/GDP profile from deteriorating given its appalling growth outlook,” said Riddell.

“As Italy or Spain or whoever’s bond prices collapse, the borrowing costs rise. As the borrowing costs rise, the interest costs steadily rise and the fiscal situation deteriorates.”

“As peripheral sovereigns blow out, banks need to raise more and more capital to cushion themselves against the cost of future sovereign restructuring, but this bank capital will get increasingly expensive just at the time that the banks need it most,” Riddell wrote.

Warning that rising sovereign and bank borrowing costs will lead to credit rating downgrades in both Italy and Spain, Riddell is worried the confidence genie is now out of the bottle.

“Italy doesn’t have the luxury of Japan, where 95 percent of Japanese sovereign debt is domestically owned.

In Italy, despite the talk of strong domestic buyers, the reality is that only half of Italy’s sovereign debt is domestically owned and the international investors are clearly getting very nervous.” “When the confidence genie gets out of the bottle, it’s very hard to get it back in again,” he wrote.