Sell The Politics, Buy Italy

by: Matthew Cianci

Italian stock market at an attractive entry point for a 6-12 month trade.

ECB will remain accommodative.

Credit spreads will remain in check.

Italian sector make-up is highly cyclical.

Five Star Movement can be a positive catalyst.

Italy is beleaguered with a host of issues - high structural unemployment, a millennial generation not motivated to work, political strife, and an underperforming stock market. Despite the bears in the headlines the last few weeks, Italy could still be a nice macro trade since the ECB is still accommodative, credit spreads will remain in check, Italy is unlikely to leave the euro any time soon, and recent history suggests populist-led political reforms prove to be pro-cyclical economic catalysts.

An often-cited consequence of Italy's unattractive economy is the credit quality of their debt-issuing companies - mostly below investment grade. In the case of the European high-yield debt market, Italy is the largest country weighting (Italian corporate debt makes up over 17% of the BAML HY Euro index). It is important to know there's a close correlation between high-yield bond and equity performance. As described in an Alliance Bernstein whitepaper: "High-yield bonds, like equities, are strongly linked to the business results and fundamentals of the companies they represent." So naturally, if one is bullish the high-yield index, it would make sense to be bullish the underlying equities as well. Since Italy is the largest weight in the index, Italian stocks should continue to perform well along with the Euro HY Index being led by Italian corporate debt.

Chart created within Excel.

The current financial market backdrop sets up an attractive scenario for Italian HY issuers: The ECB's bond-buying program has led to a scarcity of sovereign (and now corporate) bonds, driving investors into riskier parts of the capital stack such as high yield. This demand shift has pushed HY interest rates down as well - yields down, bond prices up - and when the capital markets are "open" to debt issuers, it allows companies who need it most (usually those below-investment grades) to more easily finance their operations. If the cost of capital for risky Italian companies is low, then profits and margins should stay elevated, all else being equal. Over the past few years, as the ECB has kept financial conditions easy, Italian equities have outperformed other developed non-US countries (MSCI EAFE index), and its performance tracks the tightening corporate bond spreads closely. In this case, Factset was unable to provide European HY spreads, so European BBB spreads are used as a close proxy.

Chart created from Factset.

An important factor for high-yield performance is inflation. It is important to understand that in an inflationary environment, high-yield bonds outperform investment grade bonds. There are several reasons for this. At a high level, if inflation is rising, typically nominal growth is as well, which usually means positive top line growth. Looking at the typical root cause for inflation - accelerated economic activity - it leads to businesses doing well enough (and being busy enough) to raise prices. Since debt is a fixed cost, inflationary environments offer an opportunity for companies to more easily cover their obligations since the price of everything else is rising. Looking at the last 12 months for the European debt markets, high yield is the top performer when compared to investment grade private and sovereign counterparts. This can be attributed to the accelerating economic activity and slowly rising inflation, according to the ECB.

Chart created within Excel.

On the topic of inflation in Europe, it is important to understand that although we talk about aggregate European inflation, it differs drastically at the national level. In the chart below, core eurozone inflation has been rather stagnant, but Italian inflation seems to have broken out to the upside (the recent downtrend in Italian inflation is a direct result of tough year-on-year comparisons from the spike in inflation last year, but the trend should continue higher going forward). The ECB, unlike the Fed, has a single mandate and that is to guide inflation to "close to but below 2% over the medium term." At the beginning of 2018, the market was pricing in a ~50% chance of an ECB rate hike by the end of the year. Today, this probability is less than 4%. This is a direct result of the ECB being unable to stimulate inflation as fast as they would hope for the entire eurozone region. With the market telling Mario Draghi to continue his accommodative monetary policy until next year, loose financial conditions should remain. In the below chart, you can see the core inflation metric the ECB watches (blue) has been relatively benign the last few years while regions like Italy have seen a breakout in higher inflation (brown). This means Italian credit spreads should remain in check and business activity in Italy is likely to continue at a faster pace than the rest of the eurozone.

Chart provided from Factset.

The Italian equity market is made up of highly cyclical sectors, consumer, energy, and financial companies. These sectors are "cyclical" because their relative performance tends to depend heavily on the business cycle. As growth accelerates, they will perform well and vice versa. In the below chart, EWI, as it is the largest, most liquid ETF following the Italian equity market, is being compared to the EFA ETF that follows the broader index of developed, non-US countries, and IEV, which follows all of MSCI Europe. If inflation, energy prices, and nominal growth are accelerating faster in Italy than the rest of Europe, it would make sense that the country's stock market should continue to outperform given it assigns a weighting ~20% greater to those sectors than the rest of developed, non-US countries (EFA) and also Europe (IEV).

Data sourced from Morningstar.

When looking at the fundamentals, Italian stocks also show attractiveness from a growth, valuation, and yield perspective. Given all of the risks in the headlines, it should come as no surprise that Italy trades at a discount to most developed countries - even Japan. The low valuation is a simple reason for the above-average dividend yield as well. However, as the inflation and nominal growth story continue to play out in the slow-moving European recovery, Italy's forward EPS growth appears more attractive to almost all developed countries (except the US benefiting from a one-time growth acceleration from tax-reform).

Data sourced from Factset.

The largest part of the Italian risk premium stems from their political situation. Although this appears to be a unique situation as there are many moving parts, the controversy is, in fact, similar to previous events in the last two years. The Brexit vote to leave the European Union and Trump's surprise election win in 2016 were both called "populist votes," meaning the surprise outcomes were a result of the average voter wanting a change from the popular elite. The same thing is happening within Italy. The populist-led Five Star Movement developed out of frustration with the political establishment - sounds familiar? - that is now looking to fix a stagnant economy and renegotiate immigration rules within the EU. The original agenda also wanted to leave the euro, but it's looking less likely one of the most indebted countries and third-largest economy in the EU actually leaves the euro. The populist movement's popularity among young voters also makes sense given how public the Italian millennial generation has been about their frustrations - many even refusing to work. According to, although Italy's national unemployment is 11.4%, 37.1% of Italians between 15-25 years old are unemployed - almost double the eurozone youth unemployment. As the Five Star Movement takes over, the most important leading economic indicator to look for over the coming months will be consumer confidence. Consumer confidence is important because it leads to consumer spending and borrowing, which can lead to higher profits and then increased hiring and wages. After both populist outcomes in the U.K. and U.S., consumer confidence moved higher and led to solid stock market gains, there's reason to suspect the same result in Italy.

Chart created from Factset.

From a contrarian perspective, Italy is setting up to be an attractive opportunity. Attractive valuations and growth prospects, a pro-cyclical index make-up, a still accommodative central bank, and a populist catalyst make this an interesting opportunity for risk-tolerant investors. EWI is the iShares ETF that follows the MSCI Italy Index (unhedged). For investors not willing to long the euro, iShares has a hedged version of the same index, HEWI. To long Italy for the next 6-12 months would mean one believes the ECB will not get increasingly hawkish, HY credit spreads will remain in check, Italian inflation will outpace eurozone inflation, and Italian consumer confidence should increase after the Five Star Movement's rise to power.

Disclosure: I am/we are long EWI. 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.