Brittle Italy

Posted: May 22, 2018 11:43 AM
Brittle Italy

The current crisis in Italy is a great illustration of the perils of investing in a country simply because its market is 'on sale'. The idea of a 'value trap', an investment which is at low valuation but which still turns out to be a bad investment, applies to whole countries, not just individual companies.

Italy was one of a small number of countries which have had starring roles in the European debt crisis which began in 2010, but arguably still continues to roil the continent's markets. This has placed Italian equity markets at bargain basement prices. But as anyone who has ever visited a bargain basement knows, not everything down in the cellar deserves to be bought: some of what is there has earned its way to the discount table.

As of the beginning of this year, on a broad array of valuation measures, Italy was attractively valued with prices well below historic averages.

As the chart below shows, at the beginning of the year investors who focused only on Italy's attractive valuation were rewarded. For a time.

(The blue line is Italy, red is Global Dow. Courtesy of TradingView.)

But things turned for the worse in May, when Italy's market plunged while FTSE's international index rallied, making Italy a significant underperformer.

(The blue line is Italy, red is Global Dow. Courtesy of TradingView.)

What happened? The Five Star Party revolt happened. The party is considered quasi-fascist by European elites, who are pretty quick to drop that accusation at anyone who is skeptical of the European Union -- and the Five Star Party and their partners, The League, are both pretty skeptical of the EU. Investors are clearly wary of the new coalition. But a principles-based approach to investing is based on being wary before the storm comes.

The international equity index I work on, Vident Core International Equity Index (VIEQX), held Italy at an underweight both compared to our average country allocation and as a severe underweight compared to cap-weighted indices. That underweight was in place before the unexpected populist victory; before the big market sell-off.

Why? Because Italy is not an economically resilient nation. It's demographically disastrous with a huge percentage of its population too old to work (or at least old enough to get government pensions so that they don’t need to work). That means that there is a demographic head-wind pushing against growth and towards deficits. Deficits are okay, when they're within certain limits and you have the kind of growth which allows the country to grow their way out of the debt (or at least to grow enough to stop the debt from growing its way out of the capacity of the economy to service it). But Italy is an extremely high-debt, low-growth, low-demographic-prospect-for-growth company.

It has better than average scores on diversity because it has a relatively robust history. But its legal environment, demography, and fiscal control are way below average. Its level of productivity is below the mid-point on our index. It's a problematic country in many ways.

Bottom line, at some point it might get low enough in price and might adopt enough growth policies to overcome the overall fragility of its economy. Thankfully, the coalition is talking about tax cuts. But it's also talking about increased welfare spending. As things stand, this nation is brittle -- that is, unable to be relied upon not to break when put under pressure. The new coalition has its work cut out for us, and the wise course of action is to make it prove itself to us, not with promises, but with actual growth policy achievements.