Italy: plain sailing, for now
The Italian economy is doing well in the short term but the long-term outlook is less clear
• A general election empowered new populist parties in Italy
• Political instability has ensued
• Investors are focusing on recent economic growth
• The new government’s policies could shift the economic outlook
The FTSE MiB, Italy’s main stock market index, rose by 10% in the two months after the general election that took place in the country earlier this year. The March election left a lasting impression on Italy’s politics but in its aftermath the country’s equity market seemed disconnected from short-term political developments. Investors showed signs of nervousness at times but focused on the positive outlook for the Italy’s economy.
Silvia Dall’Angelo, senior economist at Hermes Investment Management, says: “In a way, we’re used to political instability in Italy. Markets have discounted political instability after the election, since they understood the terms of the electoral law, which implied a hung parliament.”
The results of the vote represent a historic rejection of the establishment. The ruling Democratic Party, led by former prime minister Matteo Renzi, received a crushing defeat, with its coalition earning just 22.9% of the vote in the lower house and 23% in the senate. The winners were a party and a coalition that have been branded as populist by commentators. The Five Star Movement (M5S), a political movement founded by former comedian Beppe Grillo in 2009, whose programme included both left-wing and right-wing policies, earned almost a third of the vote. A centre-right coalition, led by Matteo Salvini’s Lega, which included controversial former prime minister Silvio Berlusconi, received about 37% of the vote for both houses.
Neither the M5S nor the centre-right coalition had enough seats to form a government. As a result, the vote was followed by more than two months of negotiations between the two forces. At the time of writing, a Five Star-Lega government, with Berlusconi steping aside, seemed most likely.
Investors would be right to question the impact of some of the policies discussed during the negotiations. The final draft of a joint programme includes a reversal of the 2011 pension reform, a fiscal reform involving large tax cuts and a wide-ranging universal basic income programme. All these measures would still require a significant expansion of the budget, with repercussions for the country’s fiscal balance and relationship with the EU. The parties also signalled their intention to drift away from the union altogether, with their call to redraft the main EU treaties.
This is what leads some experts to see Italy as an existential threat to the European project, particularly in the event of a recession. Salman Ahmed, chief investment strategy at Lombard Odier Investment Managers, says: “I rank the euro-zone as the biggest risk in the system, bigger than the US and China. This is because of the many flaws in the project, which have not been addressed during this recovery. The backstops for euro-zone members that run into trouble are not strong enough.”
It is impossible to predict exactly how the relationship between a eurosceptic Five Star-Lega government and other euro-zone members will play out. Even in a best-case scenario, investors in Italy would be spooked. However, the behaviour of the markets during the post-election period shows how important it is for investors to focus on long-term economic fundamentals, rather than short-term noise.
Several indicators suggest Italy’s economy is in good shape. Following the euro-zone crisis, GDP growth finally materialised in 2014, and has accelerated slightly. The European Commisison forecasts growth to be about 1.5% in 2018, in line with last year’s figure.
Speaking at an IPE’s Real Estate Global Conference in Milan in May, Fabrizio Pagani, the head of office of Italy’s finance ministry, emphasised the good news about the country’s economy. The recovery, he says, has been driven by a resilient manufacturing sector, which reached record levels of output last year.
“Exports have been extraordinary,” he says. “Last year was another record year with an all-time high of more than €500bn and a 7% rise from the previous year. We have a very significant trade surplus and have become the seventh-largest exporter in the world. We are only one of five countries that has a manufacturing trade surplus of over €100bn.”
Thanks to the outgoing government’s efforts, the labour market has also recovered. A labour reform known as the Jobs Act contributed to the creation of one million jobs in four years. The country has seen the highest rate of employment ever, with female participation growing strongly. However, notes Pagani, only one third of the one million jobs created are open-ended contracts. At the same time, unemployment remains well above the EU average.
The main driver of growth has been private business investment. The outgoing government created strong incentives for entrepreneurs by slashing corporate tax to 24%, from the previous level of 27.5%.
The country has also become more attractive for foreign investors. In the 2018 Foreign Direct Invesment (FDI) Confidence index published by AT Kearney, a management consultancy, the country was in tenth place – three places up on the previous year.
In terms of fiscal policy, the outgoing government has taken what Pagani calls a “narrow path”. The government sought to rebuild confidence in the country’s public finances while making sure it did not suffocate growth with too much austerity. The budget deficit was 2.3% last year, and the forecast for 2018 is 1.6%. Primary surplus is relatively high, reaching 2%, and the debt-to-GDP ratio, although still high at 131.5%, has declined from the peak reached in the midst of the euro-zone crisis.
Naturally, there are significant structural bottlenecks, according to Pagani. In particular, the state machine is slow and a lack of public investment is constraining growth. There are resources available, says the civil servant, but they are not being channelled properly.
Pagani did not mention some of the key weaknesses of the Italian economy such as woeful productivity growth and stagnant incomes. Even private business investment is lower than in 2007, according to figures from Eurostat, the EU statistics agency. However, investors have focused on the recent signs of strengths rather than long-term weaknesses. This, along with a general improvement in corporate earnings and low equity valuations, has benefited Italy’s stock markets.
Tristan Hanson, multi-asset fund manager at M&G, is among those who finds the endemic pessimism about Italy overdone. He has held equity positions in Italian banks and futures on the overall stock market index. Hanson points out that the Italian market has been one of the best performing equity markets in the world in recent months. His positions in banking stocks have benefited from the reduction of non-performing loans (NPL) in the country.
He says: “Two years ago, people were very worried about Italian equities. There were headlines about Italy being Europe’s next disaster. Those fears haven’t come to fruition, and investors have been able to make strong gains in that market, not because it’s a fantastically fast-growing economy, but just because it’s beaten than some very pessimistic expectations.
“It’s those kind of headlines that should make a value investor think whether there are, in fact, some opportunities. If we see continued growth in the euro-zone, that should be good for profits, and Italian equities are good value on that basis. Of course, we rely on nothing too radical happening on a political level,” adds Hanson.
Nadège Dufossé, head of asset allocation at Candriam, also supports the case for investment in the Italian market, but finds that the long-term picture is more problematic.
“Over the short term we are positive on Italy. We still think it could outperform euro-zone equities, because the economy is recovering later than other economies. It’s a good time for Italian equities to perform well, reflecting a cyclical rebound, which started from a very low level,” says Dufossé.
She adds: “In the long term, there remain a lot of questions, concerning not just reforms, but also productivity in the country. It’s complicated to make a longer-term call on Italian assets because on the political side we don’t have visibility. A coalition government may not be able to make significant reforms, and when the next crisis hits, perhaps in two or three years, Italy may face particular problems, particularly with its sovereign debt position.”
Michele Morganti, senior equity strategist at Generali Investments, broadly agrees. He says: “The level of stock market valuations in Italy does not give rise to particular concerns, and the slight slowdown in profit estimates recorded in the last couple of months appears to be physiological for now. Our concerns are focused on the longer-term outlook. Continuing reforms at national level and following the path of EU integration are critical to avoid risks once the economic cycle turns.”
What is almost certain, says Hermes’ Dall’Angelo, is that the new government will allow for fiscal slippage. “There has been some improvement on the fiscal side,” she says. “With some reasonable assumptions on nominal growth, the primary surplus, which has been positive since the 1990s, and on interest rates, I think the debt-to-GDP ratio has the potential to stabilise and come down slightly in the next few years. If we were to see changes such as a pension reform, my view would become less optimistic.”