Italy s Politics Drives a Wedge Between Its Stocks and Sovereign Bonds

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1 Italy s Politics Drives a Wedge Between Its Stocks and Sovereign Bonds June 13, 2018 by Charles Roth of Thornburg Investment Management Risk to the euro resurfaces in an unlikely governing coalition and challenging economic agenda, but Italy s top stocks don t face the same perils as its government bonds. If political risks around elections are typically framed as binary, market reaction doesn t always play out according to script. Sometimes, despite consensus expectations, it s risk on in one asset class and risk off in another, such as when the FTSE 100 Index soared for months following the Brexit referendum, even as the 10-year gilt yield fell before recovering to its pre-brexit level by late Then there s Italy, where political drama, economic challenges, and market reactions routinely confound conventional wisdom. Two months after Italy s general election produced a hung parliament, the two biggest populist parties managed to form a coalition that President Sergio Mattarella approved, but only after rejecting the Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 coalition s first designated economy minister. Mattarella had viewed Paolo Savona as too great a risk to the euro, which replaced the lira at too high a rate nearly 20 years ago and has badly undermined the competitiveness of Italy s storied manufacturing sector and broader economy ever since. Savona will now instead serve as Italy s minister of European Affairs. But the gyrations in Italian debt and equity markets continue in surprising ways. That s because the governing coalition is led by the left-leaning Five Star Movement and the right-wing League party, which suggests governing instability more than political harmony. While both parties want to curb immigration and have historically expressed skepticism toward the euro, Giuseppe Conte, their pick for Italy s new prime minister, told reporters they have never spoken of abandoning the euro, adding that was never on the agenda. That makes sense, as recent opinion polls show 50% to 60% of respondents favored remaining in the eurozone, while roughly 20% to 29% backed leaving it and the balance were undecided. Still, the Five Star s push for a basic universal citizen s income for the poor and unemployed and more spending on health care, alongside the League s proposal to slash taxes with a lower, two-tiered flat tax, don t necessarily enhance fiscal stability in the eurozone s third-largest economy. Italy s $2.3 trillion in sovereign debt amounts to a whopping 132% of GDP, more than double the 60% limit in the Maastricht Treaty for eurozone admission. The limit requires that member countries exceeding it must steadily reduce their debt load. Although the new government has inherited a primary fiscal surplus, austerity clearly isn t part of its program. Credit markets have noticed, and sent the yield on the country s 10-year BTP sovereign bond from an April low of 1.72% to an end-may high of 3.16%. In his first speech as prime minister, Conte didn t mention the euro or doing away with a 2012 pension reform that lifted the country s retirement age. Nonetheless, the BTP yield, which had ebbed back below 3% in early June, pushed up to 3.06%, reflecting doubts that the government s preference to lower debt ratios via fiscal stimulus and economic growth, rather than with belt-tightening, will pan out. If Italian credit spreads were flashing red, though, Italian stocks have painted a different picture. The FTSE MIB Index started the year at 21845, climbed to a May high of 24544, and two weeks later fell back to where it began the year. Remarkably, the index s total return just more than five months into the year was 1.5%, not far behind the Euro STOXX Index s (SXXE) 2.4% year-to-date total return. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Though Italian politics are difficult to call, the resulting volatility does present market opportunities, says Matt Burdett, associate portfolio manager at Thornburg. As the political headline noise intensified, short sellers circled Italy equity index exchange traded funds. And as they traded lower and dragged the index-constituents down with them, active investors could pick up attractive stocks at bargain prices. Italian energy producer Eni SpA, for example, tops the index constituents. It sells the oil it produces into a dollar-based commodities market, and derives just a third of its revenue from Italy, Burdett points out. Utility Enel SpA is nearly equal in its index weighting, but sources only half of its revenues from its domestic market. Another top constituent, Atlantia SPA, operates a toll-road network and is in the process of acquiring Spanish toll-road operator Abertis Infraestructura SA. Once complete, less than half of the combined company s earnings before interest, taxes, depreciation, and amortization will Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 come from Italy, Burdett adds. Banks, of course, are the big market worry, given their exposure to Italian sovereign debt. While the European Central Bank holds just less 20% and foreign creditors mainly institutional investors, including other central banks about a third, more than half is held by Italian residents, and the bulk of that by Italian banks and insurers. But Italy s top insurer Assicurazioni Generali SpA, which is also a top index constituent, sources less than two-fifths of its revenues domestically. As for Italy s banks, it s worth pointing out that the sector is in far better shape than it was the last time the eurozone s monetary stability was at risk in 2012, having sold tranches of their non-performing loans in the years since. To be sure, at 14.4% in the first quarter, NPLs among the country s top 10 lenders remain towering, but they re down from more than 20% three years ago. In the same period, their collective NPL coverage ratio has risen to 55% from 42%, and they re also quite well capitalized, with an aggregate CET1 FL ratio of 11.7%. 1 Alongside improving fundamentals, including significant cost cuts, Italian bank valuations are cheap, with the top lenders trading anywhere from 0.6x to 0.9x price-to-tangible book. And as long as rates don t rise too high, their net interest margins will benefit. Of course, continued political uncertainty could affect credit demand and investment, Burdett warns. That would be a shame, as Italy s gross fixed capital formation has been rising since early 2013, hitting an annual 4.5% in the first quarter. He points out, though, that the League s main constituency in Northern Italy, where the bulk of Italy's private sector wealth is located, views the euro in the same light as the majority in the national polls, favoring it. They don t want to see the value of their assets sharply slashed by a resurrected lira. It wouldn t help their populist agenda, Burdett points out. There are no guarantees that Italy s new anti-establishment coalition won t implode. But there are also plenty of reasons why economists generally put the odds of Quitaly at 10% to 15%, and those of Italy remaining in the eurozone without concessions from Brussels at roughly 60%, and staying in the monetary union with concessions at 25% to 30%. If the new government can find a way to streamline Italy s regressive welfare system and better target social spending with a qualified citizen s income, the net effect could be positive. If tax reforms include lower labor and payroll taxes, and Italy s 11% unemployment rate falls as a result, the net economic effect could also be positive. It s also noteworthy that, within the coalition, the League s public approval ratings have been rising of late, while those of the Five Star Movement have been slipping. That could focus the minds of those now in power who want to increase spending without simultaneously undertaking market-friendly structural reforms. Headlines out of Italy may be scary. But there are reasons why its volatile blue-chip stock index has held in line with the broader European equity market, even if its sovereign bonds haven t. 1 Basel III Common Equity Tier 1 to risk weighted assets ratio Read more Global Perspectives from Thornburg Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

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