“Italy is a better bond bet than Britain.”
That was the headline on an article in last Monday’s FT by Erik F Nielsen, chief economist at Italian bank UniCredit.
In it, Nielsen argued that there shouldn’t be such a large gap between Britain and Italy’s borrowing costs. The two economies share many similarities, and in some ways, Italy is better off than Britain. In fact, he suggested, holders of Italian debt would “continue to be happier in 2013 than those staying in gilts.”
His timing was unfortunate, to say the least.
By the end of the week, Italy’s former prime minister Silvio Berlusconi had yanked his support for current leader Mario Monti. Italy was plunged into political turmoil, stocks fell, and bond yields rose.
But I think Nielsen has a point. In fact, I think this is a great buying opportunity.
Italian politics – back to business as usual
After a brief period of near-calm, Italian politics is back to business as usual. Silvio Berlusconi now plans to run for election. Even by the standards of the modern politician, Berlusconi is a self-serving, egotistical opportunist. He’s probably more interested in winning back power to resolve his various legal problems than in helping out the Italian people.
Archbishop Angelo Bagnasco of Genoa summed it up well in his comments to an Italian daily paper: “What leaves one aghast is the irresponsibility of those who think of fixing themselves when the house is still burning.”
The end result is that the fragile sense of confidence that the ‘technocrat’ Mario Monti brought to the country has been shattered. Monti now plans to step down as soon as his 2013 budget becomes law. That means the election will probably be held about a month early, in February.
Italian bond yields shot up (in other words, the country’s borrowing costs rose), while Italian stocks fell.
It’s little wonder. Monti has been a favourite with the eurozone’s leaders. His reforms were not as significant as some would have liked, but at a time when Spain has often seemed in the process of tearing itself apart, he has managed to keep Italy out of the limelight.
This matters mainly because if the eurozone wants to hold together, then more than anything, it needs political leaders who know when to behave. As long as the voters stick with pro-euro politicians, the grand project can survive.
With Berlusconi wading back in and happy to promise whatever it takes to get re-elected, the risk of an anti-austerity, anti-euro leader in one of the biggest nations in the eurozone has risen sharply.
Imagine if Britain had joined the euro
But how much does this matter to investors? I’d argue not a lot.
For a start, Berlusconi’s chances of being re-elected are slim. And even if he did get in, I doubt he’d end up being anti-euro. Even the Greeks – who really are being squeezed hard by austerity – still voted to stick with the euro earlier this year. The Italians are not going to opt out now.
As for the economy – Nielsen made some interesting points in his piece comparing Italy and Britain. The two nations are very similar in many ways. Probably the biggest difference from a financial point of view is the fact that we have our own currency, and the Italians have the euro.
Take that out of the mix, and it’s hard to say which of the two countries would be in the most trouble. If Britain had actually joined the euro, I suspect we’d probably have ended up like Ireland – brought down by our bloated banking sector. House prices might have halved. ‘Austerity’ would mean double-digit pay cuts rather than below-inflation pay rises.
Of course, if we’d been in the euro, we’d also be one of the ‘too big to fail’ countries. So the European Central Bank might have been forced to print as many euros as it took to bail us out. Or maybe we’d have brought the whole currency down with us.
So perhaps europhiles as well as eurosceptics should be grateful that Gordon Brown was too much of a control freak to allow Tony Blair to hand that much power to Brussels.
In any case, being outside the euro has enabled Britain to win time by leaning on the Bank of England to print money and support the bond market. In Europe, countries have had to work a lot harder to get their central bank’s support.
Yet it’s hard to see how money-printing has benefited Britain in the longer run. Beyond reigniting the property bubble, we don’t seem to have many ideas on how to get growth going, beyond a vague desire to increase exports. Sir Mervyn King has regularly mentioned that a weaker pound would be a good thing, in order to boost our overseas sales.
Trouble is, while sterling fell by 25% between mid-2007 and mid-2009, says Nielsen, “UK exports increased only by 11.9% (in volume) during the following three years, barely keeping up with the growth in global trade.” Italy, despite the handicap of euro membership, saw a 21% increase.
Worse still, last year, the share of Britain’s exports going to Brazil, Russia, India and China actually fell to 5.2%, below where it was in 2008. Italy’s grew to 7.4%, up from 6% in 2008.
Why it’s worth buying Italy
Nielsen clearly has a line to push. I wouldn’t buy Italian government debt. It’s too risky. I wouldn’t touch UK gilts with a ten-foot bargepole either.
But when it comes to companies – that’s a different question. The UK stock market isn’t monumentally expensive, on a cyclically-adjusted price/earnings ratio (CAPE) of around 12.5 (as of end October). But it isn’t dirt cheap either.
The Italian market on the other hand, trades on a CAPE of around seven. From that sort of level, research suggests that you can typically expect returns of around 10% a year compounded over 10 years.
Now there’s no guarantee that this will bear out – there never is. There are plenty of reasons to worry. (Indeed I fully expect to see a long list of them in the comments section). There always are when markets are this cheap. That’s the only reason markets ever get this cheap.
But of all the measures you can use to predict the future direction of the market, the CAPE is the best, as my colleague Tim Bennett points out in the latest issue of MoneyWeek magazine. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
So I think it’s at least worth allocating some of the equity section of your portfolio to an exchange-traded fund tracking the Italian market. I’ve used the iShares FTSE MIB (LSE: IMIB).
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