mercoledì 8 agosto 2012

Is it time to invest in the Italian equity market?

The economic data released over the last week confirmed that the Italian economy is in a dire recession:
1)      The Q2’s GDP contracted by 0.7% q/q – slightly better than market expectations at -0.8% q/q. It was the fourth consecutive quarterly decline: -0.8% q/q in Q1 ’12, -0.7% q/q in Q4 ’11 and -0.2% q/q in Q3 ’11. The year over year change fell from -1.4% in Q1 ’12 to -2.5% in Q2 ’12.
2)      In June, the Italian industrialproduction fell by 1.4% m/m, 1.7% q/q and 8.2% y/y.
The leading indicators released over the last few weeks signaled that a recovery of the Italian economy is not imminent:
1)      The Istat business confidence index was at 87.1 in July – only slightly above the 3 year low at 86.5 posted in May. The index signaled that the industrial production may contract by 10% y/y in Q3;
2)      The Istat consumer confidence index signaled that the consumer spending will continue to remain weak in H2 ’12 for the negative outlook of the labor market. According to the latest Eurostat’s data, the Italian unemployment rate rose to a multiyear high of 10.8% in June
However, despite the negative economic scenario, the Italian equity market strongly rebounded over the last few weeks: from the year-low at 12295 posted on July 25th, the FTSEMIB jumped by almost 20%.
The main reason behind the rebound of the equity markets were the expectations that the ECB may intervene in the secondary market to lower the government bond yields in Spain and Italy. Indeed, the equity market rally started after the ECBpresident Mario Draghi said on July 26th at the Global Investment Conference in London  that the ECB “will do whatever it takes to preserve the euro” and continued after the ECB announced at the end of the last week monetary policy meeting that it will start buying the Spanish and Italian government bonds on the secondary markets if the two countries will ask for the intervention of the EFSF/ESM.
Following the ECB announcement, the Italian government bond yields declined: the 2 year yield fell from 5% to 3.08% and the 10 year yields fell from 6.6% to 5.9%.
A steep decline of the government bond yields in Italy will have a strong impact on the Italian economy as:
1)      It will lower the interest expenses on the huge public debt (close to 120% of GDP);
2)      It will improve the outlook for the banking sector, which is highly exposed on the Government bonds;
3)      It will lower the cost of financing for the non-financial corporations.
For this reason, a further decline of the long-term Government Bond yield – i.e. a decline of 10 year BTP yield below 5.5% - is crucial for buying the Italian equity market in a medium term perspective. Since 1994 a simple trading strategy of buying the Italian equity markets (we used the Comit index as a benchmark) at the end of the month when the 10 year BTP yield was below the previous year yield and exiting from the market in the opposite case gained a 121% performance versus the -5% of a buy and hold strategy.
Another positive sign should be a rebounded of the business confidence index. In the past, a bottom of the business confidence index anticipated not only an improvement of the economic activity but also the start of an upward trend of the equity market. The next Istat business confidence index will be released on August 30th.