As the majority of EU investors continue to follow the aftermath of the Brexit and its political repercussions, a more threatening development has emerged from the Italian banking sector. Italy is facing a debt crisis as total non-performing loans (NPLs) emerging from the private sector reach a dangerous level. WSJ writer, Simon Nixon, writes:
"Italian banks are sitting on a combined €360 billion ($401 billion) of bad debts, this includes €200 billion of loans to borrowers now judged insolvent, which banks have on average written down to 45% of their nominal value but which the market appears to value at closer to 20% of their nominal value, which implies the system is short of around €40 billion of capital."
To put things into perspective, during the financial crisis, NPLs, at its peak, in the US, made up only 5% of the country's private debt. For Italy, these loans are now more than 18% and have doubled in the past 6 years alone as many debtors continue to struggle in the country's low-growth environment. The benchmark index for the Borsa Italiana (FTSEMIB) captures the country's underperformance through its 27.94% decline in the past year, which completely eliminated any gains reported in 2014 and 2015.
The index's 5-year return of -13.24% confirms Italy's dilemma as the country struggles to achieve growth under the current EU policy structure. Despite this underperformance, investors may be interested in pursuing a more speculative strategy by profiting off the momentum changes in the Italian market.
Speculating on the political or economic results of the nation's debt crisis usually involves owning the affected banking stocks, which can be extremely volatile. The better option is to implement exchange traded funds, which can more accurately track the performance of the economy. Exchange traded funds, also known as ETFs, are marketable securities that offer an accurate way to gain exposure to an economy through a basket of equities.
Unlike the risk that comes with investing in individual companies, buying the market ensures both an accurate and more stable strategy, which better reflects the changes in market confidence. The three ETFs which offer Italian exposure are the iShares MSCI Italy Capped ETF (NYSEARCA:EWI), the iShares Currency Hedged MSCI Italy ETF (NYSEARCA:HEWI), and the Deutsche X-trackers MSCI Italy Hedged ETF (NYSEARCA:DBIT).
To evaluate these funds, three types of criteria are used: (1) the fund size, also known as net assets (2) the trading volume, and (3) the allocation strategy. The net asset value and investment strategy of the fund are directly related to the type of exposure the product offers the user. Conversely, the trading volume and volatility of the equity allows an investor to determine the cost of entering and exiting a fund based on the bid/ask spread.
Before considering the available ETFs, it is important to understand the economic landscape and inherent risk that comes with investing in Italian exposure. The size and importance of the nation cannot be understated from a global perspective as it is currently the 8th largest economy in the world and 3rd largest in the Eurozone. Unfortunately, the global collapse of 2009 left a lasting impact on the nation as overall GDP has fallen by 12.2% since pre-recession levels.
This lack of strength has translated to persistently high youth unemployment levels (36.9%), which essentially destroys the future potential of the younger generation. Further concerns emerge when considering Italy's inflation rate, which has declined consistently since 2012 to the current -0.4% level as of Q1.
Overall, the weakness of Italy's economy has disabled its ability to achieve any sustainable growth. The negative inflation rate limits the growth of earnings for the business sector, which leads to lower margins and fewer jobs created. Without this job creation, the nation's economic activity slows down as many young and able workers remain unemployed and lose confidence in the system set out to reward them.
It is difficult to see how the country is able to overcome these systemic challenges, which all contribute towards the worsening of Italy's economy. Without the confidence and support needed to enable further policy measures, the country has found itself in a situation where economically it needs to act selfishly to capture any growth but is legally limited by the union's policies. Speculative investors should be the only ones considering exposure to the nation as the long-term stability of the economy remains questionable.
Short Term Strategy - Italian Banking Sector
For investors who are comfortable in adopting a more speculative strategy, the following year will offer many short-term trading opportunities to play the momentum changes in the Italian market. The main focus will revolve around the negotiation process and potential bailout package allowed under current EU regulation. Unfortunately, newly implemented policies have changed the bailout procedure for distressed EU financial institutions, which raises several questions. WSJ contributor, Simon Nixon, explains:
"Under new EU rules that came into force in January, no public money can be used to support failed banks until private-sector creditors accounting for 8% of the bank's liabilities have been bailed in. If Italy is forced to stick to the rules, it could face multiple bank failures, which could mean heavy losses for many ordinary retail savers, who own up to €250 billion of bank bonds."
Through the new bailout structure, the EU targets four main groups to absorb much of the financial burden that comes from providing emergency liquidity. This "bail-in" process means that shareholders, junior debtors, senior debt holders, and large depositors all must participate in the "bailing-in" of the institution by allowing their holdings to be written down in order to accommodate these emergency funds.
Unfortunately, with the systemic differences that exist in the Italian banking sector, the newly implemented EU policy actually targets middle class savers rather than the intended upper class segment. Unlike the banking network in the US where the larger institutions dominate the mortgage and lending space, Italy has a much more community-centered system whereby smaller lenders fully serve their surrounding market.
With 650 different lenders in the country, Italy has one of the most concentrated lending sectors in Europe. The core problem originates from these lenders who do not have access to any secondary market to monetize their loans. What results is a regional bank sitting on its loan book while issuing additional bonds to access further lending capital. Due to this intricate community network, these bonds are sold to savers who lack the financial knowledge to protect their holdings.
What results in the current environment is that any bail in process wipes out the savings of these middle class bondholders who are fully invested in their local lenders. During the bail-in of 4 Italian lenders in 2015, over 12,500 families who bought more than €430 million in junior debt lost everything due to this mis-targeted policy. It seems that Italy's unique banking system has hurt the country under current EU policies, which raises major questions moving forward.
For speculative investors, the negotiations in the following months will move the market strongly as any indication of a more agreeable solution should be bullish for domestic markets. While the Union's current stance is against the loosening of regulations, the reality of the situation remains clear, Italy cannot operate under current bail-in procedures.
Destroying the savings of Italy's middle class is counter-intuitive to the EU's goals of protecting taxpayer dollars. For those willing to speculate on the outcome of these negotiations, implementing ETFs is one of the better options to accurately track market sentiment.
iShares MSCI Italy Capped ETF
The iShares MSCI Italy Capped ETF offers a quality mix of both volume, volatility, and pricing strength. The fund has a net asset value of $625.11 million while its strong average monthly volume confirms that investors will be able to quickly enter and exit the equity with a minimal bid/ask spread. The main concern for investors when evaluating the value of this ETF is the relatively high beta ratio of 1.38, which exceeds the average metric seen among EU-focused ETFs. In line with the inherent volatility of the fund, the 1-year return of -28.47% successfully mirrors the underperformance of the Borsa Italiana index in the past year.
When considering the fund's portfolio, from a sectoral perspective, EWI's top 5 sectors are the financials (28.14%), utilities (22.53%), energy (21.37%), industrials (13.99%), and consumer discretionary (10.3%). The main concern when considering this portfolio composition is the fund's heavy exposure to the top three industries, which make up a combined 72% of total assets. The implications of this exposure means that the fund offers strong volatility and volume to speculate in the short term, but limits the value of diversification from a longer-term perspective.
iShares Currency Hedged MSCI Italy ETF
Unlike the larger iShares MSCI index fund, the currency-hedged version is a more tailored product for macro-focused investors. For those who would like longer-term exposure to the Italian economy, this product is intended to offer a better option to protect against the persistent volatility of the EUR. By hedging the performance of the Euro through forward contracts, any declines in the currency relative to the USD will theoretically be beneficial for the ETF owner.
Unfortunately, not many investors use the product due to its limited hedging ability, which translates to a smaller asset base and limited trading volume. Since the product's inception in 2015, there is limited evidence that proves these forward contracts offer significant hedging value.
When conducting a correlation analysis between the iShares currency-hedged product to the related un-hedged version, the resulting 0.89 coefficient confirms that the price reactions of both products are almost identical even though the EUR/USD relationship continues to remain volatile. With a hedging strategy that has resulted in a 1-year performance of -29.12%, the HEWI product fails to offer any significant value to investors in the current market.
Deutsche X-trackers MSCI Italy Hedged Equity ETF
Similar to the MSCI Currency Hedged HEWI fund, the DBIT ETF fails two of the three main considerations when evaluating the fund. Its $1.72 million in net assets in addition to the nominal 390 average shares traded proves that the ETF cannot be considered in any investment strategy. As the Italian debt crisis captures global attention in the coming months, this product alongside the HEWI fund will both experience temporary increases in volatility and volume.
Investors, however, should realize that in the longer term, these products offer limited value for retail use regardless of the portfolio composition or strategy. Until these products experience sustained increases in trading volume and price volatility, the only ETF that can be realistically considered is the EWI iShares product.
iShares MSCI Italy Capped ETF - Portfolio Breakdown
When considering EWI's top 5 holdings, ENI SpA (NYSE:E), Enel Spa (OTCPK:ENLAY), Intesa Sanpaolo (OTCPK:IITOF), Snam SpA (OTCPK:SNMRY) [SRG], and Atlantia (OTCPK:ATASY) [ATL] each make up 16.47%, 12.81%, 9.93%, 5.2% and 4.62% of the portfolio respectively.
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ENI is an integrated energy producer that operates through 5 segments: E&P, natural gas, refining, chemical, and its engineering segment, which is managed through the company's ownership in Saipem Spa. The company's integrated energy model, which combines both production and refining was able to absorb some of the pressures seen in last year's oil market. Unfortunately, Q1 results were heavily impacted by cost increases as revenues declined by 38% yoy and capex cuts exceeded 17%. The holding itself remains volatile while the medium-term outlook raises questions of profitability as the company is forced to accommodate its operations to lower oil conditions.
Enel Spa is one of the largest Italian multinational producers and distributors of electricity and gas with revenues of €75 billion in 2015. Its 4% yielding dividend is more of an income play due to the equity's limited capital appreciation potential. From a financial perspective, the company's outlook remains bearish due to the high debt load and related interest expenses which limits Enel's profitability. Enel reported a net loss of €2.4 billion in 2015 primarily due to the €6.5 billion interest expense associated with its €42.6 billion in long-term debt. Unless the company is able to reduce its debt load, the medium-term outlook remains limited due to related pressures of low growth in the EU market and its debt challenges.
Unlike the limited share price declines seen in ENI and Enel, Intesa Sanpaolo has lost 45% of its overall asset value in the past year as the financial sector continues to suffer in the current debt crisis. Intesa is Italy's largest banking group offering both retail and commercial services to over 13 million customers throughout the Eurozone. The Italian bank reported a net loss of €10 billion in Q4 of 2015 as it wrote off a large portion of its goodwill from the merger, which created the institution in 2007. While Intesa offers the ideal financial exposure to speculate on the changes of momentum seen in the Italian economy, from a longer-term perspective, the outlook for the bank remains extremely bearish unless the company is able to reduce its NPLs.
Snam is the European leader in the construction and integration of natural gas infrastructure, which has helped the company benefit from increased distribution volumes throughout the region. The company manages over 32,500 kilometers of natural gas pipeline, 9 storage facilities, 1 regasification plant, and a local distribution network covering 57,000 kilometers.
With a strong market position in Europe, the company has been susceptible in recent years to geopolitical conflicts between the EU and Russia due to questions surrounding their natural gas agreements. With global attention shifting towards other issues in 2015, the company has recovered from these conflicts as total transported natural gas volumes increased yoy.
Financially, the company saw costs increase by 7.6% as lower natural gas prices and lasting impacts from 2014's geopolitical events impacted the cost efficiency of distribution. Fortunately, increases of 2.3% and 3.3% in both revenue and net income compensated for this temporary expansion in costs, which translated to a strong recovery for the stock.
The final major position of the EWI fund is Atlantia, a holding company which owns the Autostrade per l'Italia, the largest concessionaire on the country's highway system. With 2015 revenues of €5.3 billion, the company offers another income opportunity through its stable 4% dividend.
Its fundamentally strong market position has translated to net income increasing by 26.5% yoy with a projected 4.5% CAGR for the next five years. Alongside Snam, Atlantia is another solid holding which is protected by its decade-long concessionary agreements allowing the company to manage these respective motorways.
While holdings like Snam and Atlantia provide great income opportunities, the energy and financial exposure seen in EWI's top three holdings limits the longer-term outlook for the fund. The overall quality of the portfolio's equities remains questionable when considering the growth opportunities in the Italian market.
While strong dividend equities are beneficial in a stable environment, the volatility of the market has resulted in capital losses due to large declines in share prices. With investors remaining bearish on Italian exposure, the indirect impact of this sentiment will only hurt the fund's performance in the longer term.
Putting Things Into Perspective: Technical Analysis
^Sourced From Yahoo Finance
In addition to the strong volume and net asset value of the fund, the EWI ETF provides a large amount of historical data in order to compare the current underperformance of the economy to previous economic events. From a share price perspective, the ETF has reached one of the lowest price points in its history. When comparing Italy's debt crisis to previous global collapses, the EWI has never fallen below current levels which confirms the nation's weak outlook.
From a speculation perspective, readers can employ a technical analysis by using indicators like the money flow index (MFI) or relative strength index (RSI) to better understand the current environment. These technical indicators combined with statistical results will offer a better perspective of the current pricing strength in order to determine whether a short-term play on market confidence can be considered.
To increase the significance of these technical indicators, the statistical results are calculated based on share price information dating back to 1996 when the product was first introduced. After conducting the technical analysis, investors should be bullish on the short-term prospects of the product as the latest indicators suggest the fund is currently oversold.
Both the MFI and RSI are below their respective averages and medians while the money flow index also remains lower than its lowest quartile of data. The main consideration regarding the MFI indicator is its high standard deviation of 11.69 which does raise some concerns regarding the volatility of the index.
Fortunately, the distribution of data exhibited by the quartile analysis confirms that even with this inherent volatility that exists in the index, the MFI ratio remains historically low confirming the bullish sentiment. With the product's current oversold state, investors can be confident that from a technical perspective, the equity is ready to break out if Italy is granted bailout support.
Italy's golden years are surely behind the country as its once applauded financial system has failed to fully adapt to the modern global economy. The nation's future remains bleak as the economy struggles to move past the private debt burdens left behind following the recessions of 2009 and 2011. Attempting to invest in the long-term potential of Italy is incredibly risky when considering the nation's underperformance in the past 7 years, thus it's unrealistic to assume that these fundamentals will dramatically change in the coming years.
While the EU has been focused on reforming the region's financial infrastructure, Italy is among the only major economy that has failed to implement the necessary policies to control their concerning debt load. The country now finds itself in a position where it needs to protect the future of the nation by negotiating against current EU policies, a situation which will end up similar to the events seen in Greece last year.
The market should remain optimistic on the outcome of these results as the option of letting Italy's economy fail, either through no bailout package or enforcing the current "bail-in" process, threatens the stability of the EU. For speculators, the outcome of these negotiations provides several opportunities to profit off short-term market volatility. To successfully capture the market's movements, using the iShares Italy MSCI ETF offers the best way to enter and exit the market in a short time frame while protecting against individual asset exposure.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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