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Research Edge Position: Short Italy via the iShares etf EWI

The media has had a field-day with the marital status and personal relations of Italian Prime Minister Silvio Berlusconi over the last months. Apt for inappropriate comments, Berlusconi has recently been quoted saying that "he never paid a woman" and doesn't "understand what satisfaction there is if there isn't the joy of the chase." Suffice it to say that Berlusconi's private life has gotten more attention than the ailing Italian economy in recent weeks.

We're currently short the Italian equity market via EWI, a position we initiated on 6/19 based on overlapping quantitative and fundamental factors. In Europe we've maintained a bearish bias towards countries with financial leverage and over-extended balance sheets. Our short thesis holds acutely for Spain and Ireland who are suffering from the bursting of a decade-long housing property boom as well as Switzerland and the UK, which have high leverage to the financial industry.  At a point earlier this year we were short Switzerland via the etf EWL and the UK via EWU. As an aside, today Bank of England Governor Mervyn King said that banking problems may make the economy's escape from recession a "long, hard, slog."

Because American-style bank "Stress Tests" have not been issued in Italy (or most of Europe), Italian balance sheets remain hazy. Although the Italian financials have proportionally lower foreign exposure than their competitors in France and Germany, meaning that they have not felt the fallout from global real estate and derivatives to the same extent, that domestic bias has historically helped to obscure issues for prolonged periods (a situation exemplified by the Parmalat case).  The continuing decay at Italian banks was underscored by the recent divesture by UniCredit SpA, Italy's biggest bank. Yesterday the bank announced plans to transfer some 640 Million Euros of property assets to a real-estate fund to boost capital and is planning to sell at least 1 Billion Euros of covered bonds. Given these lingering concerns, the fact that the composition of the Italian etf EWI includes a 40.10% weighting in the Financial sector raised a major red flag for us, making it easy to pull the trigger when the quantitative set up provided by price action became attractive.

We believe that as European economies work through depressed levels of production, struggle with rising unemployment and decreased appetite for exports from their main trading partner (Eurozone), governments that over-extend their balance sheets (budget balances) with debt, will see greater tightening of credit, which will push out growth for countries like Italy. This point is supplemented by data from FactSet that shows General Government Debt as a percent of 2008 GDP stands at 105.8% for Italy, compared to 65.9% for Germany and 68.1% for France.  

We continue to have our Eye on the credit markets. Today Italy sold 9.5 Billion Euros of government securities.  To date the Italian credit rating has not been downgraded, unlike its peers Spain, Ireland, and Portugal, yet the chart below of the German vs. Italian 10Y Treasuries clearly shows there is a risk premium in owning Italian debt. The 120 basis point premium over German and US bonds demanded by investors for the 2 and 10 year paper issued today does not bode well for future refinancing on public debt -which  currently stands at over 100% of GDP -a higher leverage ratio than Germany, France, Spain or the UK.    

From a fundamental basis, Berlusconi passed a 2 Billion Euro economic stimulus package in February to aid Europe's third largest economy, which is forecast to contract 5.3% this year by the OECD, a downward revision from a March estimate of -4.3%. Italian CPI came in at 0.8% in May (the lowest in 40 years), down from a target level of inflation of 3.5%, said EuroStat. The contraction will benefit consumers, but indicates the level of contraction the country is feeling. Compared to the Eurozone CPI average of 0.0%, it's a call-out that Italian inflation is running higher. Recently we've seen improved Italian business and consumer confidence reading in June, yet the surveys are forward looking and may be overly optimistic for the next 6 months. Q1 unemployment rose to 7.3% from 7% in the previous quarter, according to the Istat statistics office, with forecasts of 9% late this year and next. We expect sentiment to tick downwards as unemployment rises and predict very modest growth for Italy next year.

The Italia All-Share index is crawling around -1% YTD, similar performance to the S&P500 and German market (DAX). We're looking to increase our European exposure. Stay tuned.

Matthew Hedrick

Analyst

The Wrong Headlines - it1

The Wrong Headlines - it2