PERSPECTIVES
JULY 2016
This is for investment professionals only and should not be relied upon by private investors
A hot Italian summer
The UK’s referendum vote to leave the EU gave a boost to nationalist and
populist parties, triggering a rise in political uncertainty across Europe.
While the Spanish election result shortly afterwards reassured markets,
this is likely to be just a temporary calm, as Italy, and Italian banks, move
onto the radar as the next source of political shockwaves.
Prime Minister Renzi’s attempt to renegotiate EU conditions of a financial
sector rescue package puts him in direct conflict with EU counterparts. In
addition, Renzi faces a crucial vote at home in October which could lead
to a change in government.
As political risks rise, Italian government bonds will come under pressure
and underperform other peripherals. Bank bond investors will however
fare better than equity holders, as long as systemic issues are fully
resolved.
Italian banks in the firing line
The UK’s vote to leave the EU put the Italian banking system back on investors’
radar. With its highly indebted government and large stock of non-performing
loans (NPLs), could Italy be the next domino to fall? As long as investors fret
and negotiators disagree on how to deal with the country’s failing financial
sector, Italian assets will remain volatile.
While the environment for Italian banks is challenging, the systemic risk they
pose gives Italy’s Prime Minister Matteo Renzi bargaining power to negotiate a
support package in aid of the Italian banking system with the EU. A positive
outcome and a recovery in bank shares and bonds would see him back into the
public’s good graces ahead of Italy’s own national referendum in October.
Renzi recognises that, in order for any initiative to be effective, it must be a
system-wide solution. But this is difficult to achieve because a large share of
subordinated bank debt and equities is in the hands of retail investors, for whom
a bail-in would be costly. This is why the government is keen to avoid triggering
EU state-aid procedures and bail-ins under the EU Bank Recovery and
Resolution Directive (BRRD).
The BRRD’s objective is to avoid taxpayer-funded bailouts of unsound or failing
credit institutions and investment firms. It sets out a harmonised, EU-wide
framework for dealing with failing financial institutions, in which their rescue is
primarily financed by private resources. Government capital can only play a role
if at least 8% of liabilities are bailed-in - implying ‘burden sharing’ for these
investors.
FEDERICO WYNNE joined
Fidelity International as a senior
credit analyst in 2010 covering
global financials.
Prior to joining Fidelity, Federico
was a global financial sector
analyst at Generation Investment
Management. He has also held
similar positions with a focus on
pan-European financials at Morley
Fund Management and Goldman
Sachs Asset Management.
ANDREA IANNELLI is an
Investment Director at Fidelity.
Andrea joined Fidelity in 2015,
and represents the Fidelity fixed
income investment team to
institutional and wholesale clients
in Southern Europe and Latin
America.
However, there may be some leeway for Italy’s beleaguered policy makers.
Article 32 of the BRRD allows for public financial support for an institution via a
precautionary recapitalisation, if stress tests or asset quality reviews identify a
capital shortfall and there is a risk of systemic financial instability. It so happens
that the ECB is due to publish new stress test results at the end of July, offering
more clarity on the state of play of Italian banks.
In case of a precautionary recapitalisation, state-aid rules would not apply,
sparing those retail investors who hold a large share of the banks’ lower-quality
debt any bail-in losses. But EU creditor countries worry that such interventions
create a moral hazard elsewhere, reducing the incentive for sound credit
management. In the case of Greece, the most recent example of a
precautionary recapitalisation, regulators therefore imposed burden sharing via
a “voluntary” debt-for-equity exchange of senior and subordinated debt.
These discussions are a sensitive topic in Italy after the fall of four small Italian
banks in 2015, when the bail-in procedures were applied and retail investors in
subordinated debt suffered capital losses. Following a public outcry, the
government was forced to reimburse retail investors. Renzi is keen to avoid a
repeat of last year’s events.
To this end, the Italian prime minister asked the EU for a temporary suspension
of the bail-in rules, which would allow the Italian government to inject up to €40
billion of fresh capital into the banking system. This compares to circa €85
billion of system-wide net NPLs. Such an injection would roughly match the
amount of additional capital required for banks to maintain a 12% core equity
tier 1 ratio while reducing bad loans in an accelerated fashion. Crucially, banks
would then have sufficient capital to maintain lending and intermediation
activities and would be able to dispose of legacy NPLs more easily. But Renzi’s
request was quickly rebuffed by the EU on concerns that any concession would
undermine the BRRD and the broader EU banking union project.
Chart 1
Gross NPLs are now over €200 billion
200,000
Chart 2
Coverage ratio has increased and is now just under 60%
EUR million
57.5%
55.7%
54.3%
150,000
52.6%
51.4%
100,000
48.0%
48.7%
50,000
0
1998 2000 2002 2004 2006 2008 2010 2012 2014
SMEs
Corporate
2010
2011
2012
2013
2014
2015
May
2016
Households
Source: Fidelity International, Haver, July 2016
PERSPECTIVES | A hot Italian summer
Source: Fidelity International, Banca d’Italia Statistical Bulletin, July 2016
2
Outside of the EU’s framework, a second version of the support fund Atlante
may well be on the cards. The original Atlante fund was launched earlier this
year and named after the mythological titan who held up the heavens. It is a
government-backed private initiative with the dual mandate to buy shares in
Italian lenders and facilitate the disposal of NPLs. With rumoured firepower
between €3 and €6 billion, the new fund would focus exclusively on NPLs.
These would be purchased at a price close to book value, so that the impact on
banks’ profitability would be minimal. However, ambitious as they may be, the
funds are hampered by lengthy and cumbersome due diligence on NPLs: the
original Atlante has yet to execute its first transaction.
Although Renzi’s request for a suspension of bail-in rules was rejected, wider
negotiations between Italy and the EU are still ongoing. The EU, on its part,
may see this as an opportunity to finally restructure and stabilise the Italian
banking system, as Spain did with its banks in 2011. It is likely, however, that
this would lead to losses for both institutional and retail investors. While the
government could seek to reimburse retail investors, as happened in 2015, it
would be a blow to the public image of the ruling Democratic Party (PD) at a
time when it is already in a weak position.
Chart 3
Italian banks have improved their capital ratios
Chart 4
Italian assets will remain volatile until there is more clarity
on banks
14%
21,000
100
12%
110
10%
120
19,000
8%
130
6%
140
17,000
4%
150
2%
160
0%
ISPIM
UCGIM
MONTE
BPIM
15,000
Mar 2016
170
Apr 2016
May 2016
Jun 2016
Jul 2016
FTSEMIB All Share Index
2013
2014
2015
Source: Fidelity International, Haver, July 2016
Ita - Ger 10yr spread (RHS, bps, inverted)
Source: Fidelity International, Bloomberg, 12 July 2016
The referendum that could backfire
Renewed political instability adds to Renzi’s and the markets’ woes after he tied
the government’s survival to the success of comprehensive political reforms.
The PD party, with Renzi at its helm, has made considerable efforts in pushing
through structural reforms to streamline Italy’s political and economic
framework. The reform that the government has spent the most political capital
on is the constitutional one, appropriately labelled “the mother of all reforms” by
observers given the impact it will have on Italian politics if fully approved.
PERSPECTIVES | A hot Italian summer
3
The constitutional reform can be split into the electoral reform (or “Italicum”) and
the Senate reform. The electoral reform, passed in 2015, aims to reduce
instability in the Lower Chamber of the Italian Parliament. Under the new
electoral law, the party that receives the most votes controls the Lower
Chamber with 55% of the seats. Under the “Italicum”, the Italian electoral
system becomes similar to the French one, with the executive and the Lower
Chamber fully aligned.
But the cornerstone of Renzi’s mandate has always been the Senate reform.
This constitutional change would bring an end to the perfect bicameralism that
currently defines the Italian political system, in which the Lower Chamber and
the Senate have equal powers. Once the reform is fully approved, the Senate
would see its powers meaningfully reduced, becoming a consultative chamber
with a legislative remit limited to regional matters. The constitutional reform
would therefore shift the centre of political gravity towards the Lower Chamber,
boosting the majority party’s power to pass laws and reforms.
In 2015, Renzi announced that the constitutional reform had to be approved by
the Italian electorate directly via a referendum to be held in 2016. While no date
has yet been set, it is likely that the referendum will take place in late October or
early November. Renzi also aligned the referendum to his premiership,
committing to resign should it not pass. Since the announcement, however, the
PD’s popularity has suffered a significant fall, to the advantage of right wing and
populist parties who have turned the constitutional referendum into a de-facto
vote of confidence on Renzi’s rule.
Chart 5
The 5SM is now head-to-head with the PD in the polls
0.0%
10.0%
20.0%
30.0%
40.0%
Chart 6
The referendum has become a vote on the government
60
PD
30.5%
50
M5S
30.0%
40
LEGA
12.8%
FI
Others
11.6%
4.9%
FDI
4.0%
SI
3.5%
NCD-UDC
3.1%
Source: Fidelity International, Termometropolitico, 8 July 2016. Shows average of
all poll results collected in the week to 6 July 2016
PERSPECTIVES | A hot Italian summer
30
20
10
0
In favour of the
Against the
Constitutional reform Constitutional reform
Feb 2016
Don't know /
Undecided
Jun 2016
Source: Fidelity International, Il Fatto Quotidiano, using Demos and Pi poll as of
12 July 2016
4
The Five Star Movement (5SM) in particular gained considerable ground,
winning mayoral elections in key cities such as Rome and Turin. The latest polls
show 5SM in first place, leaving the PD trailing in second. Renzi has also faced
opposition from within the PD, and has had to rely on the support of smaller
centre-right parties to maintain his majority particularly in the Senate. This
support does not come without a price, with the referendum an opportunity for
centre-right parties to exercise further leverage over the government. This
could, for example, result in a watering-down of the electoral law which would
allow for coalitions to form, thus giving smaller parties the upper hand.
Despite the ideological differences between the PD and the 5SM, the latter has
much to gain from the constitutional reform. The strong public support that it
currently enjoys make the 5SM a serious contender at the next elections, and it
would benefit should these be run under the new electoral system with no need
to form coalitions with other parties.
Supporting the referendum would, however, align the 5SM with the government,
and risk alienating a large part of their supporters who see them as the antiestablishment party. They therefore have to publicly oppose the constitutional
reform, while perhaps hoping that it passes and they manage to keep the
positive momentum they currently have.
To this end, and to broaden their appeal to other more moderate voters, the
5SM has recently changed its stance towards Europe, distancing itself from the
very anti-European position of the UK Independence Party, with which they
were historically aligned. The party has now come out in favour of Italy
remaining in the EU, thus reducing the possibility of an “Italeave” should they
ever get into power.
With all the ongoing developments within Italian politics, Renzi finds himself in
weak position. The strong alignment between Renzi’s premiership and the
referendum result has transformed it into a vote on the government rather than
on the reform itself, potentially jeopardising the reform process altogether, and
throwing Italy into yet another political crisis.
The uncertain environment is likely to weigh on Italian government bonds over
the coming months. BTPs are likely to underperform Spanish Bonos in
particular, given Spain’s more stable political backdrop.
Chart 7
Little chance of an “Italeave”
Chart 8
Uncertainty will weigh on Italian government bonds
40
bps
30
8%
20
26%
10
Leave the EU
0
Remain in the EU
-10
Undecided / No answer
-20
66%
-30
-40
Jan 2015
May 2015
Sep 2015
Feb 2016
Jun 2016
Italy - Spain 10yr spread
Source: Fidelity International, Termometropolitico, 1 July 2016.
PERSPECTIVES | A hot Italian summer
Source: Fidelity International, Bloomberg, 12 July 2016.
5
Bondholders get paid
As investors, we would welcome a full restructuring of the Italian banking
system. The October referendum could push the government to take difficult,
but badly needed, decisions.
Using the case of Spain as a template, an effective solution should lead to
broader consolidation in Italy’s financial sector, a trend that is already in place
but that needs to accelerate.
Given the constraints of the BRRD fresh equity capital is needed in order for
banks to accelerate their balance sheet clean up without triggering bail-ins.
New capital can only be convinced to participate if the recovery process for
corporate bad loans is expedited well beyond what current judiciary reforms
envisage.
The stronger players would be able to manage a gradual reduction of legacy
NPLs and minimise the impact on income and capital. Smaller entities in a
weaker capital position, on the other hand, are likely to be absorbed or
unwound.
National champions will be able to manage an accelerated reduction of legacy
NPLs whilst smaller entities with weak capital may well be absorbed or
unwound. Larger banks would ultimately benefit from a bigger market share, a
stronger capital position and improved profit margins. Further rights issues and
capital injections will negatively impact equity holders whose stake will be
diluted. Fixed income investors with exposure to the larger and more stable
players will, however, benefit from improving balance sheet as NPLs are
gradually offloaded and as the perception of industry and country risks subside.
In order for a rebound in Italian assets to take place, more clarity is required in
what remains an extremely fluid situation. Nevertheless, fixed income
instruments issued by the larger Italian financial institutions offer value after the
market-wide sell off, given the government’s strong desire to shore up the
financial sector and reduce systemic risk.
Chart 9
Unicredit Group equity vs. debt
Chart 10
Intesa Sanpaolo equity vs. debt
110
110
100
100
90
90
80
80
70
70
60
60
50
40
ISPIM Subordinated Debt
UCGIM Subordinated Debt
50
ISPIM AT1 Debt
UCGIM AT1 Debt
40
Intesa Sanpaolo SpA
Unicredit Spa Equity
30
Jan 16
Feb 16
Mar 16
Apr 16
May 16
Source: Fidelity International, Bloomberg, 12 July 2016.
PERSPECTIVES | A hot Italian summer
Jun 16
30
Jan 16
Feb 16
Mar 16
Apr 16
May 16
Jun 16
Source: Fidelity International, Bloomberg, 12 July 2016.
6
Conclusion
In the confusion after the UK’s ‘Brexit’ vote, markets have re-priced risks
elsewhere in the EU. Many investors are particularly concerned about Italian
banks’ unsustainably high NPLs. It looks likely that this uncertainty will persist in
the coming months and Italian assets will remain volatile at least until October’s
crucial referendum.
The country’s financial system could come under further pressure without a
resolution of the financial sector’s undercapitalisation, but Italy and the EU are
at loggerheads over the role investors should play in this rescue. Large retail
bond holdings mean that any bail-in would be political suicide for the
government, while the EU is worried about moral hazard of tax-payer support
and the future of the banking union.
Badly-needed constitutional reforms are hampered by a public backlash against
the establishment and the government. October’s referendum has been turned
into a vote of confidence on Prime Minister Matteo Renzi, whose position looks
precarious in current polls. Another political crisis in Italy would not only set
back political reforms, but also reduce the chance of a full resolution of the
issues that Italian banks face.
With only a few months to go until the referendum, Renzi will spend all his
political capital on avoiding a bail-in, in an attempt to regain sufficient
momentum and public support to win the vote. The EU will not give in easily to
Italy’s requests, and volatility will remain elevated, in what promises to be a hot
summer for Italian politics and Italian banks.
PERSPECTIVES | A hot Italian summer
7
Important Information
This document is for Investment Professionals only and should not be relied on by private investors.
This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any
other party without prior permission of Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the
solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or
regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or
appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions
where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or
products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on
their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of
illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and
analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This
material was created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has
not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content.
Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated
jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers
information on products and services and does not provide investment advice based on individual circumstances.
Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL
(Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and
supervised by the Swiss Financial Market Supervisory Authority FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476
Kronberg im Taunus. For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill
House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ.
In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL
Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea)
Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited 15F, 207 Tun Hwa South Road,
Section 2, Taipei 106, Taiwan, R.O.C. Customer Service Number: 0800-00-9911#2
IC16-91
PERSPECTIVES | A hot Italian summer
8