Italy’s cabinet is preparing to authorize an increase in its national debt to bailout its rickety banking system. This is not a good sign given that Italy is Europe’s most indebted nation relative to GDP outside of Greece. It has also not seen a decrease in its debt to GDP since 2007. It may now be time to short Italy.
When Italy’s constitutional referendum was rejected in a landslide earlier this month, market orthodoxy predicted that Italian stocks would tank as a result of political instability. Surprisingly, they did not, and European stocks in general simply shrugged off the results and kept trading higher. The iShares MSCI Italy Index ETFÂ (EWI, Financial) is actually trading 8% higher despite calls of doom for Italian markets if the vote did not pass. The fact that Italian stocks have not crashed yet only makes a short position more attractive.
The whole situation is similar to what happened in the United States when Donald Trump upset Hillary Clinton to be elected the 45th president. Just as political pundits predicted Clinton would win and were proven wrong, market prognosticators predicted that a Trump victory would upset markets and were proven even more wrong. Since Trump’s election, the S&P 500 has risen 5.5% and hit new all-time highs.
So why should Italian stocks fall soon if all these market reactions to political outcomes are so unpredictable? How markets react to politics is a matter of sentiment and guessing how traders will feel about a particular outcome. Going up against financial reality is another thing entirely. Italian banks have been troubled for a long time and will not be able to tread water much longer without a recapitalization or bailout, and private sector recapitalization is looking less and less likely. Monte Dei Paschi, the world’s oldest bank founded in 1472, just had its request for an extension for its recapitalization efforts denied by the European Central Bank, which means a government bailout may be the only option going forward. This is why the Italian cabinet is preparing to do just that.
As the fate of banks are tied together from mutual loans, when one bank falls, others are more likely to follow. Even if a bailout is reached with the Italian government, bank shares still tend to fall on a government bailout and do not recover to previous levels very quickly. Even when they do recover, it takes years. Just take a look at the largest bank stocks since 2008. Citigroup Inc. (C, Financial) and Bank of America Corp. (BAC, Financial) are nowhere near pre-2008 levels, and banks that did recover to new highs like JPMorgan Chase and Co. (JPM, Financial) and Wells Fargo & Co. (WFC, Financial) took five years to do so.
The bailouts that have kept Greek banks technically in business have certainly not levitated Greek bank stocks at all, and the 2013 Cyprus bail-in did not bring Cypriot banks any higher. With recent history as a guide, it makes sense to short Italian ETFs now before any bailout becomes official.
On top of that, we have rising interest rates in Italy and across Europe. Interest rates on the Italian 10-year bond are up 95 basis points since August, which will make increasing the Italian national debt even more dangerous. It may only be a matter of time before Italian stocks become Greek stocks 2.0.
Of the iShares Italy ETF holdings, 30% are Italian financial stocks, its largest segment holding, making it an ideal candidate to sell short on the cusp of what looks to be systemic banking trouble. Markets may be able to shrug off a referendum or even an election, but when banks fail, there is no resisting the pull of low tide.
Disclosure: No positions, but may short EWI within 72 hours.
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