With the Italian government and their proposed budget still being punished by the bond market pushing ten-year yields up through 3.50%, levels not seen since early 2014, another sector of the economy is hitting the headlines, banking.
Around 500 years ago during the Renaissance era a number of charitable money lenders were created across what is now Tuscany in Italy to combat the damaging effects of loan sharks. Back then merchant bankers still limited their business to the noble or political and religious elite until Franciscan Friars persuaded the Vatican to found a bank that would set interest rates at cost and take collateral. These banchi di pegn (or pawnbrokers) and similar banks then begun to spread with one rich trading city-state, that of Siena, creating their very own such bank with taxpayers’ money. This innovative project grew a core portfolio of agricultural loans along with other banking business to a previously neglected populous. After a significant loss financing the exploration of Christopher Columbus in 1492 its rotating structure of leadership instilled a risk-averse culture and lending practice.
The Italian government has announced the date for the referendum on Constitutional Reform as December 4. This had been touted as a key event as Matteo Renzi publicly stated he would resign if it does not get passed: an all too credible risk given the rise of populist politics, a general backlash against austerity and the rise of the Five Star Movement in Italy. However, he has recently backed away from his statement about resigning emphasising that the referendum should be about the issue of reform and not a confidence vote on him per se; a wise move given the vote looks to be a close call with a large portion (35-40 percent depending on the poll) undecided (indeciso). There is no constitutional obligation for Renzi to immediately resign on the back of a ‘no’ vote.
European bank stocks have been under pressure: This follows on from the European Bank Stress Test which covered 51 banks representing ~70% of the banking system but excluded banks from Greece and Portugal, where some of the weakest players reside. Under the stress scenario, which critics note was weaker than the stress tests carried out on the US banks in June, the results highlighted the banks with weak levels of loss-absorbing equity capital. Of the banks analysed under the scenario 49 out of 51 had CET1 capital above 6% in 2018: the weighted average CET1 capital level improved to 13.2 percent at the end of 2015 an increase of 200 basis points over 2014 levels.
Italy holds a three star ranking under Stratton Street’s Net Foreign Asset (NFA) scoring system with a score of -32% of GDP, putting it in between the UK and the US, also in the three star bucket. The government however is highly indebted with around EUR 2.2tn of debt, about 133% of Italy’s annual economic output.
Italy is rated BBB on average by the three major agencies. According to our Euro Relative Value Model (RVM) “fair value” indicator, the 3-year benchmark should trade around 147bps over Bunds, not at 64bps where they are currently trading, which equates to an actual yield of just negative 3bps per annum. A similar picture is seen at the 5-year maturity where“fair value” is around 175bps over the German Bund curve, but they trade at just +90bps and again at a meagre yield of just 0.3% per annum.
The last week or so has been a rollercoaster ride for asset markets: the Brexit victory triggered a sell-off with some of the most pronounced moves coming from equity and currency markets, particularly sterling and the banking sector. In some cases the British banks lost up to a third of their share price value at the lows and riskier instruments such as CoCos were hit aggressively too. But even with the bounce in markets, the share-prices of Lloyds, Barclays and RBS are still at least 25% below their pre-Brexit levels with Lloyds a better performer. On announcing the Brexit result the Merrill Lynch sterling financials bond index saw its spread widen 31 basis points (currently around 38 basis points wider).
Media coverage of Brexit has somewhat eclipsed the Italian local elections results; these look to be yet another example of populist politics gaining ground in a push back against incumbent regimes and the European austerity mantra. As we have said before, creating the euro currency union between creditors and debts without a European Treasury, unified fiscal policy and fully functioning redistribution mechanisms is problematic. Under the current system, the adjustment process to reduce imbalances has taken the route of austerity which has hit the debtor nations hardest in terms of weak growth and deflationary pressures, exacerbated by the lack of debt write-offs. Greece, Portugal and Spain have already experienced a good deal of political upheaval and this week there were signs that Italy could be heading this way too.