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My Take on the Rescue Plan

At an emergency meeting this past Thursday, European leaders backed a rescue plan for Greece that was generally in line with what the market had been led to expect.

Prior to the rescue plan news, both the market and I had expected that Thursday’s summit meeting would hopefully result in a revision of the terms of Greece’s original aid package as well as a revision of the aid packages of Portugal and Ireland. In particular, the plan was expected to lower Greece’s interest rate and lengthen the maturity of its debt. The market also generally expected more clarity on the exact role of the European Financial Stability Facility (EFSF). So far, the rough outline of the plan appears to be in line with such expectations.

While some of the specifics of the deal still remained unclear on Thursday, the market viewed news of the plan as a significant positive that would help take some pressure off of Europe by addressing Greece’s solvency and mitigating some of the risk of sovereign debt crisis contagion to Italy and Spain. This was evident in both Thursday’s equity market rally and big drop in peripheral CDS spreads and 10 year yields.

Ultimately, I believe the news supports the case for risky assets such as equities and hurts the case for more risk-averse investments such as the US dollar and US Treasuries.

A Closer Look at Italy

In light of the plan possibly lowering the risk of a spreading debt crisis, my attention turns now to Italy.

Italy’s government debt is currently around €1.9 trillion, or roughly 120% of its GDP, a percentage rivaled by only Greece in Europe. Investors have remained concerned about Italy’s ability to trim its debt after warnings from both Moody’s and Standard & Poor’s in the past two months, and after local political conflict over a budget-trimming plan. According to the Bank for International Settlements, French banks in particular have large exposures to both Italian government and private debt.

While Italy has a low budget deficit, its growth has been weak and is expected to continue as such. Further, with investors’ recent decreased appetite for risk and flight to safety, Italian bond yields have widened considerably, increasing the country’s cost of financing beyond the government’s projections.

But while I currently don’t have a formal recommendation on Italy, I am turning more constructive – or positive — on the country. I think that the risks facing the Italian market are more than adequately reflected in the valuations, as the country currently trades at just 9 times forward earnings and 0.8 times book value, one of the lowest valuations among developed countries.

Disclosure: None

Source: The European Rescue Plan, Italy and Your Portfolio