I’ve been banging a drum for Italian stocks for a while. The election results, of course, put a dent in progress.
But despite the chaos, I think this is a buying opportunity. And I’m not the only one…
Arguing the Case for the Italian Economy
I was interested to read a piece from Albert Edwards at Société Générale arguing the case for investing in Italy’s economy. For those who don’t already know, Edwards is probably one of the most bearish commentators around. So when he says ‘buy’, it’s worth taking note.
Edwards isn’t at all upbeat on the eurozone. Like us, he finds it hard to believe that the euro can be sustained in the long run, due to the basic impracticality of having such different economies all bound together under the one central bank.
Nor is he particularly upbeat about Italy’s economic outlook. From a structural point of view, the country has huge problems. Among developed nations, Italy has fewer graduates (in percentage terms) than any country other than Portugal. The World Bank reckons it’s harder to do business in Italy than it is in Romania.
However, there’s one key area where Italy’s economy is in a better position than any of the other ‘peripheral’ countries. And that’s on debt.
Italy’s economy has a horrible level of official national debt (the total debt pile). It clocks in at around 127% of GDP. However, its annual overspend – the deficit – is remarkably low.
For 2012, it’s expected to come in at around 2.9%, below the 3% everyone in the eurozone is meant to stick to. That 2.9% compares to 4.6% for France, 10.2% for Spain, 6.3% for the UK, and 8.5% for the US.
In other words, while Italy’s existing debt pile is huge, its spending is actually pretty much under control. In fact, the country runs a ‘primary surplus’ of 2.5%. What that means is that if it didn’t have to pay the interest bills on its existing debt pile, it would actually be making more each year in taxes than it spends on public services.
The other ‘troubled’ countries still need ‘massive fiscal retrenchment’ in order to reduce their deficits below 3%, to meet the demands of ‘the Troika’ (the European Commission, European Central Bank and the International Monetary Fund). But, as Edwards puts it, ‘the heavy lifting has been done in Italy.’
Another piece from Fulcrum Research tries to ‘stress test’ Italy’s finances. They take three, ever-worsening scenarios. First, they look at what would happen if Mario Monti’s reforms were undone. Then they throw in a worse-than-expected recession, with the Italian economy shrinking by 2% in 2013, and 0.5% in 2014. Lastly, they chuck in a panic in the bond market, which would drive interest rates higher.
‘Remarkably, even after the introduction of these three negative shocks, the debt-to-GDP ratio would peak in 2015 and still be in a downward trajectory by the end of the decade, although admittedly just barely so.’
To put that into perspective, for all the talk of austerity, Britain’s debt-to-GDP ratio isn’t expected to peak until 2016 (according to credit rating agency Moody’s). And that’s being relatively optimistic about it.
In other words, Italy’s economy is in a sustainable fiscal position, believe it or not. And that means that it doesn’t need to do a load more austerity to keep its paymasters in the eurozone happy. What Italy really needs (as does Britain, though in different ways) is reform.
Reform and austerity are ‘the opposite of each other’, notes Edwards. Proper, structural reform, costs money. ‘If you want to open your labour market to a hire-and-fire rule, you will need policies to deal with those who are laid off. These costs may outweigh the financial benefits of reforms in the short term, but the reforms may still pay off in the long run.’
Of course, that’s not to say that we’ll get any useful reforms. Given the current political mess, it’s hard to know exactly what will come out of all this. But if Italy’s debt position is actually sustainable, then there’s no need for the ‘Troika’ to get bolshy with Italy. And equally, that means there’s no reason for Italians to throw in the towel on the euro (yet), which is arguably the biggest short-term risk.
Buy Italian Stocks
So how do you invest? At current levels, I wouldn’t touch Italian government debt (believe it or not, there is an exchange-traded fund you can buy to do this). There could easily be a spike from here if more election jitters arrive, so it just doesn’t look cheap enough.
But Italian stocks on the other hand, do look cheap. As Edwards puts it, ‘Italy is much cheaper than most countries in a cheap region.’ On a price/earnings basis, price-to-cash-flow basis, price-to-book value basis, and dividend yield basis, Italy is far, far cheaper than its long run (since 1985) average.
Yes, ‘the situation in the eurozone is indeed toxic and it will get worse. That is the opportunity. Buy Italy.’
John Stepek
Contributing Editor, Money Morning
Publisher’s Note: This article originally appeared in Money Week
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