Italy: Politics remain complex, but systemic risks abate

In the last few weeks, markets have acknowledged
reduced systemic risks in Italy, and banks’ shares have gained as a
result. Italy’s sovereign spread has declined both relative to German
Bunds (-35bps to 175bps) and Spanish government bonds (-13bps
to 60bps).

Talks among Italy’s four largest parties regarding a new proportional
electoral system collapsed. Parliamentary discussions to reform the electoral
law will resume in September – this implies that elections will likely take
place at the end of the legislature, i.e. in early 2018.
The latest polls (see Figure 1 and Figure 2) based on current electoral law
suggest that no single party would be able to achieve the majority required
(currently triggered at 40%) and there would be no clear majority for any
possible coalition. For the time being, based on the latest opinion polls,
the largest possible coalition would be one involving moderate forces – the
Democratic Party (PD) and Forza Italia. Yet, even those two parties would
not reach 50% of the electoral vote at present.
While political newsflow remains mixed, systemic risks have abated over
the past few weeks with a conclusion finally being reached on Italy’s three
troubled banks. Veneto and Vicenza were sold to Intesa Sanpaolo for 1
euro each, having carved out NPLs, burden sharing for subordinated bonds
and a state capital injection of EUR 4.8bn. Monte dei Paschi di Siena finally
received the green light from the European Commission to receive EUR
5.4bn in state capital after burden sharing of EUR 4.3bn. Following these
steps, systemic risk in Italy’s main banks has retreated significantly. In the
medium term, this should remove an obstacle to economic recovery and
improve market sentiment.

Talks of new electoral law reform to resume in September
Talks among Italy’s four largest parties regarding a new proportional electoral
system collapsed at the first parliamentary vote. Discussions will now
have to wait until after the summer meaning that general elections will
likely only take place from February 2018 onwards, after the current legislature
ends.
Based on the latest polls and on current electoral law (see Figure 1 and
Figure 2) none of the major coalitions would win a majority as things stand.
The largest possible coalition would be one involving moderate forces –
the Democratic Party (PD) and Forza Italia –, but together they would not
reach 50% of the vote, and a minority government, while possible in principle
if some political parties decided to abstain from a confidence vote,
would have limited room for maneuver and a short lifespan, in our view.
The unwillingness of the Five Star Movement (M5S) to join any coalition
implies that it has little chance to be part of a cabinet in the foreseeable
future. Thus, one cannot exclude further elections in 2018 in the absence
of a change to the electoral law or a swing in the polls.
However, the last quarter’s polls show some interesting trends (Fig. 3). The
Five Star Movement has been the main loser (falling over 2%) possibly as
a result of its perceived lackluster performance in running Rome and Turin
(two cities with M5S mayors) and concerns surrounding its anti-euro stance.
Indeed, in the last month M5S has been progressively toning down its antieuro
rhetoric suggesting that any referendum on the euro (not possible
under current law) is no longer an immediate priority.
Torn by internal divisions, PD and the other leftist parties were unable to
attract the votes lost by M5S and their share of the vote, as per polling
data, remained broadly stable. On the contrary, the centre-right, and in
particular Forza Italia – the political party led by Mr Berlusconi, rose over
2%. Forza Italia’s political campaign appears to be centered on a mix of
fiscal reform (i.e. household tax cuts), a more assertive approach to the EU,
while confirming its commitment to the euro, and a tougher approach on
illegal immigration.
Fig. 2: Possible alliances’ cumulative polls (%)
Note: Based on the 5-poll moving average of various pollsters. Five Star
Movement “M5S,” Democratic Party “PD,” Forza Italia “FI,” Lega Nord
“LN.” The spike in “Other left” comes from the creation of new leftist
political parties. Source: Index, EMG, Demos, Ixè, Demopolis, Ipsos, SWG,
Piepoli, Bidimedia, Lorien, Tecnè, IPR, Scenari Politici, UBS, as of 4 July
2017.
Fig. 3: Winners and losers in the last quarter,
% change
Note: Based on the 5-poll moving average of various pollsters. Five Star
Movement “M5S,” Democratic Party “PD,” Forza Italia “FI,” Lega Nord
“LN.” The spike in “Other left” comes from the creation of new leftist
political parties. Source: Index, EMG, Demos, Ixè, Demopolis, Ipsos, SWG,
Piepoli, Bidimedia, Lorien, Tecnè, IPR, Scenari Politici, , UBS, as of 4 July
2017
Banks restructuring in details
Good progress has been made in restructuring the Italian banking sector
over the past few months and markets have been quick to react to these
developments. The Italian minister of finance, Mr. Padoan, stated that:
“there are no further trouble hotspots such as the ones solved in the last
few days”. While we agree in principle, one can not rule out that small,
non-systemic banks may still need support in the future. However, we think
the EUR 20bn that has been set aside by the Italian government to shore
up financial institutions’ balance sheets, of which roughly half has been
used in the current recapitalizations, puts the banking sector in a more
comfortable position.
The recently approved precautionary recapitalization of Banca Monte dei
Paschi di Siena (MPS) has resolved a major uncertainty that had weighed on
the sector over the past year. In doing so, the Italian government will hold
roughly 70% of the lender’s capital. The public disbursement will amount
to EUR 5.4bn, of which EUR 3.9bn will be paid through a capital increase
and the remaining EUR 1.5bn will be used to reimburse retail subordinated
debt bondholders following the conversion of their bonds into shares.
In the past couple of weeks the acquisition of Veneto Banca (VB not
covered) and Banca Popolare di Vicenza (BPV not covered) for the symbolic
price of EUR 1 by Intesa Sanpaolo marks a further positive achievement for
the Italian banking sector. Intesa Sanpaolo’s acquisitions were supported
by government intervention of some EUR 4.8bn to offset the potential
negative impact arising from the deal and make the transaction regulatory
capital-neutral for Intesa Sanpaolo. Senior bondholders and depositors
will be unaffected by the deal, while equity and institutional subordinated
bondholders will suffer full loss absorption. Retail subordinated
bondholders, who are able to claim being victims of mis-selling, will be
reimbursed. For further details please see:”Intesa Sanpaolo: A1-EUR deal
for the Veneto banks”, dated 28 June 2017.
Both deals are positive for the Italian banking system as they show the
government’s willingness to ensure financial stability and protection of
senior bondholders within complex restructuring processes. In addition, the
state’s intervention avoided the higher costs associated with the use of the
guarantee deposit fund in the case of a disorderly liquidation. On a less
positive note, some of the costs involved in the clean-up of these troubled
institutions have been borne by tax-payers.

Italian government bonds benefited on various fronts
The recent relative outperformance of Italian government bonds over both Bunds and rating peers is a reflection of the reduced risks in the banking sector and a retreat of radical parties in the polls and regional elections. However, we think the ECB, which bought EUR 9.3bn of Italian bonds in June and EUR 274bn since inception of its QE program, has also contributed to this development. This year, the ECB has regularly bought a higher amount of Italian government bonds through its QE program than it should do according to its Capital Key rules. At the same time, it has bought Spanish bonds roughly at the required pace and shown a EUR 0.5bn shortfall in German Bunds in each of the last three months, with the latter likely due to scarcity issues.

Higher carry yield, but no compelling investment case
Even if the ECB’s purchasing pattern continues, it increases the potential pressure on Italian bonds should the ECB announce a reduction in its purchasing volume in September, effective from January 2018. We think that in the absence of heightened political uncertainty in Spain, the outperformance potential of Italian bonds over the next six to twelve months is likely limited to earning a higher carry and benefiting from a steeper yield curve (resulting in a higher curve roll-down return).

From an expected return perspective, the best place on both yield curves is currently in the five- to seven-year range, where the curves are quite steep and the potential to earn carry is well balanced compared to the risk of valuation losses resulting from a possible further rise in risk-free interest rates.

We think it would require further positive news out of Italy, or longer and larger ECB purchases than we currently expect, to trigger a spread tightening to less than 150bps over 10-year Bunds. We expect market volatility in Italian bonds to continue to exceed that of its peers and currently do not see a compelling investment case for a relative trade.

Chief Investment Office WM – UBS