Nick Wall, co-manager, Old Mutual Global Strategic Bond Fund
Italy’s outlook darkens even as markets shrug off referendum
Italy’s government bond market faces multiple risk from the country’s politics, troubled banking sector and growth outlook, says Nick Wall.
After the Brexit vote and US election, one might have expected the latest kick delivered by the electorate of an advanced economy to its political establishment to trigger spasms of unease among investors.
Yet the stinging defeat suffered by Matteo Renzi, in a referendum on the Italian prime minister’s flagship constitutional reforms, has failed to spark a disorderly selloff in his nation’s assets.
At the time of writing, Italian government bonds are weaker, but less so than in the run-up to the vote, with the yield spread against German bunds tighter than it was last week. Italian equities are actually rallying and the euro is close to flat, having trimmed losses suffered in the immediate aftermath of the result.
We believe markets have responded in an orderly fashion to the vote, which has pushed Italy into political crisis, because no establishment party will want to hold an election under the current ‘Italicum’ electoral law. Under this system, the populist Five Star Movement could win a commanding majority.
It is far more likely, in our view, that following Renzi’s resignation, a caretaker government might take office– perhaps under the leadership of Pier Carlo Padoan, the finance minister – with a mandate to amend Italicum and recapitalise the troubled banking sector.
Ahead of the weekend, investors were short Italian risk, taking a negative stance on financial assets linked to the country. Buying flows from the huge domestic market dried up in the last fortnight – suggesting Italian investors have room to open their wallets again – while the short base in Italian bond futures was large. This means that most of the selling this morning has been met with buying flows, as investors cover their short positions.
Central bank intervention
The European Central Bank (ECB), meanwhile, threatened to intervene if markets became disorderly, albeit unofficially via leaks; it would be a brave investor who takes on the central bank, especially before it holds a policy meeting this Thursday.
From here we favour a neutral stance on Italian bond-market risk. The spread versus German debt is wide, offering a significant yield pickup, but we harbour longer-term concerns.
First, it is unclear whether the banking system can recapitalise itself without help from the state in the form of some kind of bailout. Second, status-quo Italian politics implies that the country’s potential growth rate will stay low, while its debt position will struggle to improve. And finally, we see global growth picking up – weighing on developed-market debt in general – while Italian bonds are likely to remain weak, as the market prices in a slower pace of ECB asset purchases.
Richard Buxton, Head of UK Equities
Rob James, Financials Analyst
Italian banks: kicking the can (again)
As far as Italian bank reform is concerned, the result of Sunday’s referendum means that nothing has really changed, and as such the status quo will prevail, explain OMGI’s Richard Buxton and Rob James.
Legislation to enforce foreclosure on bad debts in Italy is now almost notoriously dysfunctional. As a result, the country’s lending institutions have a long tradition of carrying bad debts on their balance sheets for periods of up to a decade or more. For the sake of comparison, this contrasts with a figure closer to six months among UK banks.
The sheer length of time for which bad debts remain stubbornly sitting on Italian banks’ balance sheets in turn makes the prospect of properly provisioning for associated losses at best unpalatable. Put simply, therefore, they don’t. As a result, the value of provisions relative to the value of bad loans (sometimes known as the ‘coverage ratio’) is extremely poor.
Naturally, this has not gone unnoticed. The regulator, in the form of the European Central Bank’s Single Supervisory Mechanism, has placed considerable pressure on Italian banks to close this ‘coverage gap’. The challenge, however, is in the sheer scale of the task in hand.
Plugging the gap
Taking the example of one of the country’s largest lenders, Unicredit, the ‘gap’ equates to approximately €13 billion, a figure that is disconcertingly close to – indeed marginally greater than – the company’s entire market capitalisation. Any capital-raising to bridge Unicredit’s ‘coverage gap’ would need to take the form of a rights issue on a scale of 1:1, an enormous ask.
Another superficially obvious alternative approach would be for the banks to sell some of their bad loans to so-called ‘vulture funds’, investment vehicles that specialise in buying bad loans at enormous discounts to their face values in anticipation of recovering a greater proportion of the outstanding debts than the banks themselves believe to be possible, at least economically. One of Unicredit’s main rivals, Intesa Sanpaulo, has taken this approach previously.
The main problem with selling bad loans in this way is that it doesn’t actually solve the fundamental flaws in Italian legislation, and so it would be reasonable to forecast that the issue would simply rear its head again in a few years’ time.
The need for major banking reforms in Italy could hardly be clearer. Aside from a number of large players, the market is characterised by literally hundreds of community banks, each typically serving a small locality. The main client bases of these banks are constituted of small-medium enterprises (SMEs); as it stands, levels of personal debt in Italy are in fact extremely low by European standards. The issue – as much a cultural one as a legal and regulatory one – is that Italian SMEs have historically taken a lackadaisical attitude towards repaying their borrowings, with inevitable results for their lenders. The system, in other words, is broken.
In light of the referendum result, it seems reasonable to assume that Italian bank shareholders and other capital providers, including bondholders, are going to need some convincing if they are to be persuaded to inject fresh capital. This, in turn, leads to something of an impasse; the regulator is exerting ever greater pressure on the banks to improve their bad loan ‘coverage’, but the reality is that they don’t have access to the necessary capital to do so.
There have been other superficial efforts to ameliorate the situation. The ‘Atlante Fund’ was established earlier this year to buy up bad debts from Italy’s banks, but in practice this has simply had the effect of mutualising the debt.
In another effort to break the deadlock, earlier this year, the now-outgoing Prime Minister Matteo Renzi passed a decree allowing faster collection of collateral from companies. The legislation is forward looking, and so will do nothing to deal with the stock of bad debts already on banks’ balance sheets, but it could potentially help in the future.
The difficulty here, however, is that the decree implies that there must be agreement between the borrower and the lender for the collateral to be seized, something of a tall order. Of note is that the decree does not apply to Italy’s relatively small retail banking market.
In the event that the banks are unable to raise the required funds from their shareholders, or from their bondholders via conversions (this is one of the routes another major lender, Banca Monte dei Paschi di Siena is following), then the ultimate alternative is state aid. Naturally, the protagonists in this discussion are extremely keen to avoid such a solution.
If there is a silver lining to this apparent cloud, it is that the challenge of the Italian banking market is scarcely a new or sudden problem. It is, also, a uniquely Italian problem, and so we do not see these challenges spilling over into other markets. For all the drama that almost invariably accompanies Italian politics, it is almost as though, for the country’s banks at least, nothing has happened; once more, the proverbial can has been kicked down the proverbial road.