Why it’s time to pile into Italian stocks
John Stepek Jun 07, 2012
The outlook for the eurozone is deteriorating by the day. On the surface, the crisis is all about debt. But in reality, it’s all about politics. While the eurozone’s debts are significant, if tackled as a united whole, they could be dealt with. The problem is that the eurozone isn’t a united whole – it’s a group of distinct nations. And even as the markets line up to pick them off one by one, they can’t agree on how to split the bill.
On one side you have Germany, which doesn’t want to let other countries off the hook too easily. While Spain this week called for help bailing out its banks, the Germans are reluctant to do so without an official request from the country, and the imposition of austerity conditions that this would involve.
You can see why they are worried about this ‘moral hazard’ issue: ultimately the Germans will end up footing more of the bill than anyone else for a more integrated Europe, so they want to be sure it ends up happening on their terms.
On the other side, increasingly, you have just about everyone else. Europe’s troubled economies are unable to print and inflate their way out of trouble – the route chosen by Britain and America – because they are bound to the euro. So they have had no alternative but to try to cut debt the hard way: by stopping spending.
The trouble is, if you cut public-sector spending at a time when banks are crippled and the private sector is thus cutting spending too, your economy simply has to shrink.
The Greek economy shrank by more than 6% in the first three months of this year alone. In turn, unemployment is soaring, particularly among young people, and populations are rebelling against austerity measures and the governments responsible for implementing them.
The Greeks have already voted for ‘anything but this’ at their last election, and the results of the new vote on 17 June are anything but a foregone conclusion. Europe’s leaders no doubt hope the Greek people will fear the prospect of a euro exit enough to reconsider their views and back a pro-austerity coalition. But the election of the anti-austerity, left-wing Syriza seems at least as likely.
But probably the most important rejection of austerity came from the French. François Hollande came to power on a ‘growth’ platform. Whether or not he can make his promises stick in the face of jittery government bond markets is a moot point. French voters have no intention of ending up like Spain or Greece.
It’s not too much of an exaggeration to describe the situation as being a colossal game of geopolitical chicken, one that will have consequences for nations around the globe, not just in the eurozone. As The Economist puts it, “will Germans, Austrians and the Dutch feel enough solidarity with Italians, Spaniards, Portuguese and Irish to pay up?” There’s no guarantee that they will.
So what should investors do? Plenty have been ploughing their money into the ‘safety’ of British and American ten-year government bonds, yielding below 2%. But lending at sub-inflation interest rates to governments that are clearly intent on debasing their currencies seems an odd sort of safety to us. A better bet might be to buy European stocks.
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That might sound mad. Why would anyone buy stocks in these countries when the outlook is so bleak? The simple answer is: because they’re cheap. In the past year, the Spanish, Italian and Portuguese stockmarkets have each lost at least 35% of their value.
Athens is down by more than 60%. As Albert Edwards of Société Générale points out in his latest missive, based on the cyclically adjusted price/earnings ratio (CAPE – which looks at average earnings over the course of a business cycle, rather than a single year, and so smoothes out any year-to-year spikes and troughs), Europe as a whole “is back down to rock-bottom valuations, consistent with the bottom of previous long-term bear markets and lower than that seen in March 2009”.
Market historian and bear market expert Russell Napier seems to agree. While Napier reckons the S&P 500 will fall as far as 400 (from over 1,200 now) before the bear market hits bottom, in Europe, there are markets getting “very close to these low valuation levels”, he tells the Financial Times.
Napier reckons that the “trigger point” for gains will be when “a strong central bank”, either the European Central Bank, or one of the national central banks, starts “going for massive reflation”. But at current valuations, while buying now might not make much “in the next 12 months, it should be very helpful over the next ten years”.
Of all the European markets, Edwards reckons the most interesting is Italy. Why? Because Italy never “enjoyed’ an asset price bubble. As Richard Halle of the M&G European Strategic Value Fund noted on Reuters recently: “It’s much easier to make a case for [investing in] Italy than some of the other countries. Italy didn’t really have a property bubble.” So now, says Edwards, “Italy does not suffer from a rapidly deleveraging private sector holding back growth” as “in the other rapidly deflating economies”. Italian household debt is low, particularly by British standards (53% of GDP in 2010, according to the Bank for International Settlements, compared to 106% for Britain).
The country hasn’t been especially profligate in public spending terms either. As the BBC points out, although Italy has had a debt-to-GDP ratio of more than 100% since 1991, the government actually takes in more in taxes than it spends on public services. In other words, it runs a ‘primary surplus’.
The only reason it has continued to increase its borrowing is because its sclerotic economic growth has left it reliant on borrowing more money in order to meet repayments on its existing debts. Even on the gloomiest forecast, the annual budget deficit (the amount by which spending outweighs taxes) is set to come in at just 1.5% of GDP in 2013. This also means that Italy could in theory default on its existing debt and not have to raise taxes or cut spending any further in order to maintain its current level of service.
Of course, life is hardly rosy. Italy is in recession, along with most of the rest of Europe. Its hefty national debt means that any change in its borrowing costs has a serious impact on its ability to service its debts. But Italy’s real problems – as this debt build-up suggests – are structural, rather than the product of a credit boom and bust.
Economic growth has been slow for years and productivity has grown at a pitiful rate. Italy is now among the least competitive economies in the eurozone, with the highest ‘unit labour cost’ within the region, as research group Hammer points out.
Once upon a time, it would have just inflated its way out of trouble – a weaker lira would trim wages in real (after inflation) terms, making the country more competitive. But within the eurozone, that’s not an option. So competitiveness gains have to come the hard way – through reform.
That’s what ‘technocrat’ president Mario Monti is trying to do right now. As well as cracking down on tax dodging, and overhauling the pension system, he has tried to reform the rigid Italian labour market. He has so far experienced more success with the former aims than with the latter.
But overall, Edwards reckons that Italy “can emerge from this quicker than other deleveraging economies that are seeing both public and private sector deleveraging”. As a result, “it may be an interesting place to look for cheap, long-term equity investments”.
What if the euro splinters?
Of course, the elephant in the room is the euro. It’s clear that Europeans overall still want the euro as a currency. But with so many different groups, each with different interests, jockeying to have a Europe that suits their specific vision, it’s perfectly possible that a solution might not be found in time, or that events could overtake politicians’ ability to deal with them. So what happens if the euro splinters?
Partly, this is why we’d favour Italy for now over other struggling eurozone economies (although if you feel particularly bold, we look at ways to play the others below). Greece, Portugal and Spain would almost certainly have to leave the euro before Italy was next in line.
By that point, you’d expect European officials to have been scared into doing something significant to try to stop the panic from spreading. In other words, it’s unlikely that there isn’t at least a sizeable bounce to be had in Italian stocks between now and any euro exit.
Also, while Germany might be happy to make an example out of what it sees as an intransigent Greece that probably shouldn’t ever have been in the eurozone in the first place, it may be less keen to punish countries such as Portugal, Spain and Italy, which have largely attempted to drive through genuine reform and austerity measures with relatively little complaint.
But even if the euro is doomed (and we suspect that like almost all currency unions it will be, at some point or another), then it doesn’t have to spell disaster. Indeed, Bedlam Asset Management thinks that a splintering of the eurozone would in fact be the best outcome.
In its latest newsletter, the fund management group cites the 1997 Asian crisis. As with the eurozone, “Asia’s initial problem was an artificially high exchange rate; most countries had pegged their local currencies to the dollar and began accumulating dollar debt”. Reactions to the crisis varied: some countries imposed capital controls, others intervened in markets, others saw their currencies collapse. “Yet in every case, GDP was higher than on the eve of the crash within three years and accelerated thereafter.”
Of course, a eurozone break-up would be extremely disruptive in the short-term at least. But as Napier notes, European equities “are already pricing in a great deal of pain. Sometimes equities get so cheap that they can discount just about everything”, short of physical destruction or confiscation by governments.
It’s also worth considering what has happened to the ‘other’ problem economy, Ireland. The country is by no means out of the woods (it’s still part of the pejorative PIIGS acronym after all), but it arguably hit its bleakest point a few years ago when the government had to be bailed out after promising to stand behind the country’s hugely over-indebted banks.
Since hitting its low of 1,916 in March 2009, the Irish ISEQ index has jumped by more than 50% to around 3,000. The other PIIGS indices, by contrast, are only just making their all-time lows now.
The fact is, as Edwards puts it, “the macro backdrop ALWAYS looks awful when the market is this cheap. There are no such things as toxic assets, only toxic prices.” And right now, in Europe, prices are far from toxic. We look at the best ways to invest below.
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Most actively managed funds invest across Europe, so the easiest way to get wide-ranging exposure to Italy is via an exchange-traded fund (ETF). The iShares FTSE MIB (LSE: IMIB) ETF has a total expense ratio of 0.35% and simply tracks the FTSE MIB (Milano Italia Borsa), Italy’s benchmark index, which consists of the 40 most liquid stocks on the Italian market.
One reason why the MIB has suffered so much in the sell-off is due to the significant proportion of banks in the index – they account for about a fifth of the market’s value.
However, given that the market is currently so cheap – the overall price-to-book ratio is around 0.6 while the average dividend yield is a historically high level of more than 4% – we’re not overly worried about avoiding the banks, and this is certainly the easiest way for a UK investor to access the market.
Also, it’s worth remembering that any intervention by the European Central Bank would likely spark the sharpest rally in the banks, as the most beaten-down stocks.
What about individual stocks? Some of Italy’s top companies include luxury brands such as Salvatore Ferragamo and sunglasses manufacturer Luxottica. However, in common with most luxury stocks, these have been chased higher by investors who believe that China’s hard landing will fail to dent wealthy Chinese people’s appetites for designer goods. We’re not so sure about that, so we’d avoid these.
Of more potential interest for brave investors is Italy’s largest electricity provider Enel (Milan: ENEL). The good news is that, despite having recently cut its dividends to help pay down debt, the company yields around 11%, and has exposure to electricity and gas markets all over Europe as well as some in the US.
The bad news is that the group is heavily indebted, even by the standards of utility stocks – indeed, it is Europe’s most indebted utility. It’s a potential play on an Italian economic recovery (results have been hurt recently by weak demand as the economy slows down), but it’s certainly not one for widows and orphans.
Another option is Italy’s biggest manufacturer, Fiat (Milan: F). As my colleague Matthew Partridge points out, if labour reforms go through, this should help boost productivity. And if Italy ends up returning to the lira, this would benefit exporters such as Fiat.
Trading at little more than half its book value, and on a price/earnings ratio of around 5.4, Fiat looks cheap. A less aggressive
play than either of these could be oil and gas major Eni (Milan: ENI). The stock trades on a p/e of less than seven and offers a dividend yield of around 6.5%. It is one of JP Morgan’s top picks in the sector, with a target price of €21.50 (it currently trades at around €15.80). Be aware that dividends on Italian stocks will be taxed differently to UK stocks.
There is of course currency risk here. Firstly, there’s the very real risk that the euro will weaken against sterling. However, even if this happens, a weaker euro would broadly be good news for the eurozone, and stocks in the region should benefit from it.
Secondly, there’s the danger that Italy will eventually have to leave the euro altogether, and re-adopt the lira. We think it will take some time for this to happen, but even if it does, while you could expect a sharp devaluation in your holdings in the shorter term, in the longer run a return to the lira would make it easier for the Italian economy to recover.
If you’re feeling particularly adventurous, you could take a look at Europe’s other troubled markets. For Greece, the Lyxor ETF FTSE Athex 20 (Paris: GRE) tracks the Athens stock exchange. However, as our ETF specialist Paul Amery noted in a recent issue of MoneyWeek, if you believe that Greece is set to exit the euro, it might be better to wait until after the drachma devaluation before buying this one.
Otherwise, it could be a good way to bet on a short-term bounce after the election, but this really is a bet rather than an investment. As for Spain, the US-listed iShares MSCI Spain Index (US: EWP), which has a total expense ratio of 0.52%, is probably the easiest way to invest in the market, although as it’s denominated in dollars there’s an added layer of currency risk here.