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December 2016

No whiff of Brexit in Italy’s political limbo

Our chief strategist Luca Paolini says fears of a crisis are overblown - Italian and EU policymakers should be able to steer through these choppy waters.

Europe and its financial markets are once again in the eye of a political storm. 

Italy’s rejection of Matteo Renzi’s bid to overhaul the country's sclerotic legislative system in Sunday’s referendum and the prime minister’s subsequent resignation have revived fears of a fracturing of the euro zone. Under normal circumstances, the fall of an Italian government would barely register on investors’ radars. After all, the country has had 65 administrations since the Second World War. 

But these are not normal times. This latest bout of political turmoil comes at a critical period for the euro zone’s third largest economy. 

Across Italy, populist, anti-euro political parties are in the ascendancy, and there are fears they could step into the void left by Renzi’s departure. 

The economic and financial picture is equally unsettling. Italy’s output per capita has barely grown over the past 20 years while its public debt burden relative to GDP is Europe’s second biggest after Greece at 136 per cent. And then there is more pressing problem of the country’s beleaguered banking system. Unable to earn their way out of black hole of bad debt, which at EUR360 billion is equal to a fifth of Italian GDP, Italian banks are in desperate need of recapitalisation.

To some investors, Italy’s fragile financial institutions, public debt mountain and growing disenchantment with the euro zone are the three heads of a Cerberus that threatens the survival of the single currency project.

Yet there are reasons to believe that both Italian and EU policymakers are up to the challenge confronting them. 

No need to press panic button

The immediate priority for Italy is to deal with soured loans sitting on the balance sheets of its regional banks. 

The ideal solution would involve a combination of fresh capital and the imposition of losses on bank bondholders. But as many of those creditors are pensioners, recapitalisation has been the government’s preferred choice. According to our calculations, Italy’s banks need some EUR30 billion in fresh capital.

This where Renzi’s downfall has complicated matters.

With Banca Monte Dei Paschi Di Siena, the institution at the centre of the non-performing loan crisis, due to launch a EUR5 billion rights issue this week, the political vacuum is bound to make it more difficult for the bank to attract the required investment. 

The four other regional banks looking to dispose of their own non-performing loans – among them Banca Carige and Veneto Banca – are also in limbo. Meanwhile, Italy’s largest bank Unicredito may also struggle to raise the planned EUR10-13 billion in capital.  

Our view, however, is that provided a new caretaker government is installed quickly, Italy could, with intervention from the European Central Bank and some flexibility from the EU, find a way to circumvent rules preventing a state bailout of Monte Paschi. This would greatly reduce systemic risks. We also wouldn’t rule out a nationalisation of the bank, which, despite involving the imposition of some losses on bondholders, would also avert a crisis. 

Difficult for anti-euro parties to gain foothold 

In the political sphere, the most likely outcome of Renzi’s resignation is the installation of a technocratic government headed by a high-ranking official from the ruling centre-left Democratic party. The new administration would likely remain in place until the next parliamentary elections due in early 2018.

Even so, there is a chance that Italy’s president Sergio Mattarella could see fit to bring forward elections to next year. Whichever route Mattarella takes, fears that an early ballot would hand power to anti-establishment parties look overblown. 

Elections would be held under a new electoral law that will in all likelihood give bonus seats to a winning coalition rather than a winning party. This new electoral calculus will make it much more difficult for anti-euro populist parties such as the Five Star Movement to win an absolute majority and call for a referendum on EU membership.

Debt servicing costs manageable

Political concerns aside, investors are also keeping an eye on Italy’s borrowing costs. According to our model, Italy possesses among the most unsustainable debt loads in the developed world. Only Greece and Portugal are in a worse position.

Yet our analysis shows that even though 10-year Italian government bond yields have risen in the lead-up to the referendum – by some 65 basis points since Trump’s election victory to about 200 basis points - the country’s debt servicing costs are not at danger level. 

Our calculations show that for Italy to prevent its debt burden from rising over the next four years, it needs to keep its annual debt servicing costs at about 4 per cent a year. Currently, they are averaging at 3.1 per cent and unlikely to spike higher at a time when the ECB is buying government bonds at rate of EUR80billion a month.  

European assets to remain under pressure over near term

Although the underlying picture is a reasonably encouraging one, European markets are bound to remain volatile at least until the end of the year. The euro looks vulnerable to a correction in the near term although we would probably increase our exposure to the currency were it to devalue by a further 10 per cent against the US dollar, which is trading some 23 per cent above its fair value against the single currency. 

We will remain neutral European stocks for the time being. 

European equities might be trading at an inexpensive 13.5 times forward earnings against 17 for their US counterparts, but most of that discount is justified by the US’s improved economic prospects. A 10 per cent fall in the euro would change our perspective, however. A depreciation of that magnitude would boost corporate Europe’s earnings prospects, and encourage us to raise our stance to overweight.