M&G worried about current valations after Italian referendum

Stefan Isaacs, Deputy Head of M&G’s Retail Fixed Interest Team “As largely anticipated, the outcome of yesterday’s referendum led to a rejection of the proposed reforms and was followed by Renzi’s resignation. The market thus far has taken the news in its stride. Whilst 10 year BTPs have sold off on the news, 0.1% to 2.0%, this still leaves them trading inside of the highs of November of 2.2%. Credit markets have opened broadly unchanged adding further weight to the view that a ‘no’ outcome was priced into markets.

In the near term the markets will look to the ECB press conference on Thursday for any change in stance. Italian politics and volatility are nothing new. In the medium term Sunday’s outcome will make it increasingly difficult for Italy’s ailing banking system to recapitalise itself.

This will in turn continue to weigh on economic growth and continue to raise doubts about the long run sustainability of Italy with the current EU framework. We remain of the view that current valuations do not adequately compensate investors for the risks involved and remain cautiously positioned.”

Juan Nevado, Manager of the M&G Dynamic Allocation & Prudent Allocation funds “Attempting to fit the Italian referendum into a broader “rise of populism” and existential risks to the EU seem to have been overplayed. It seems that the focus of the vote was primarily domestic. Unlike Brexit and Trump, the Italian result was in line with expectations; prices had already partly moved to reflect this outcome and the initial response from markets seems muted.

FTSE MIB opened down about 2% but quickly moved back to positive territory, with banks stocks mixed and overall financials on the up. Valuations for many banks in Italy continue to look compelling, with highly negative outcomes priced in even at the banks with the healthiest balance sheets. In our view, it would not take much in terms of positive (or even less negative outcomes) for a significant re-rating.

The euro opened fragile, but then regained much of the loss. Italian government bonds have seen some weakness leading up to the referendum but have also been caught up in the broader bond sell-off of the last couple of months. We had viewed Italian government bonds as having reached unattractive yields earlier this year, but price action more recently has begun to look more interesting.

From an economic standpoint, Italy has been benefiting from a wider European improvement, but more recently it has been struggling to keep up. Retail YoY sales have moved back into negative territory in 2016 but consumer confidence is still high. Manufacturing data has slowly been improving with industrial production YoY at 1.8%, but unemployment is still struggling to fall below 11.6%. The latest GDP number at 1% YoY was positive, but there is still scope for significant improvement and potential positive surprises. And given the current valuations, these are opportunities worth exploring.

The other difference is that Brexit and Trump represented sharp breaks from the status quo. The Italian result is more complex. From a constitutional standpoint, nothing has changed and the removal of a prime minister is not unusual (Renzi’s two years in office is in line with average terms over the last 30 years).

Looking ahead, the decision to approve or reject the new electoral law, the “Italicum”, has potentially more relevance to determine the likelihood of an anti-establishment party coming to power. There is a new electoral law that needs to be approved, that will help determine if populist parties can actually take power. Except for extreme events, the impact of politics upon the economy and markets is often tangential and even in the case of large fundamental shifts such as Brexit, the effects take years and even decades to manifest themselves.

The temptations to focus on a single event, worry about the short term, and ignore fundamentals in these periods are huge. As a result, while it often seems unsatisfactory not have a strong view or forecast in the face of political events, our experience suggests that being prepared to be agnostic, accept that you cannot know too much about the future, but be prepared to respond when others think they do is the best path to generating returns.”