Rating agencies and third quarter reporting season put Italy under scrutiny

All the major global equity indices posted negative or neutral performances in October: on the Italian market the FTSE MIB recorded -1.8% (+21.8% YtD), the Stoxx Europe 600 -2.3% (+6.7% YtD), the S&P 500 -0.2% (+12.9% YtD) and the Nasdaq -0.2% (+26.8% YtD) in local currency (total return).

Energy is the only sector to deliver a positive return since the start of the month. This was due to the outbreak of the conflict between Israel and Hamas in the Middle East, which led to fears of a new rise in oil prices. The other sectors mostly performed negatively due to renewed concerns about the resilience of the economic cycle in the face of the recent rise in interest rates. The equity markets have begun to discount such an eventuality, especially in recent weeks, but the bond markets have been taking it into account for some time now, as confirmed by the inversion of the US 2-year and 10-year rate curve since the beginning of the year.

As regards Italy in particular, there has been a widening of the spread between the yield of 10-year BTPs and that of 10-year German Bunds (now stable in the 200-basis point area) as a reaction to the 2024 budget: of the €24 billion total, €16 billion will be come from new borrowing and the remaining €8 billion from spending cuts – a prospect that has fuelled fears over the sustainability of the deficit/GDP ratio. Therefore, in the next few weeks it will be important to watch for the verdict of the four main ratings agencies (Standard & Poor’s – which has already expressed its opinion confirming the rating, Moody’s, Fitch, and DBRS), since they will all be called on to confirm or revise the sovereign rating and outlook assigned to this country.

We continue to flag the underperformance of small and medium capitalisation companies compared to larger market capitalisation titles, as indicated by the performance of the Star and Aim markets, which have dropped by -11.3% and -14.7% respectively since the start of the year. So we reiterate our view that this past quarter offers an excellent window for the selective buying of those small and mid caps whose valuations are currently reduced due to the recent rate hike, but whose business models and margins have proved resilient in response to the inflationary shocks and global supply chain bottlenecks of recent months.

We are now in the early stages of this year’s third-quarter reporting season: the results reported so far (mostly relating to European ex-Italian companies) give the first tangible signs of a slowdown in the average consumer, especially in the discretionary consumption sector, and the ongoing trend of progressive destocking (i.e. disposal) of excess inventories, in the wake of the precautionary purchases brought forward in recent months. Investors will therefore make every effort to ascertain the resilience of demand (and thus the health of the end consumer), both in terms of volume and pricing sustainability.

In Italy’s case, much attention will also be paid to the reporting of banking stocks; interested investors will be keeping a keen eye on the interest margin outlook between now and the end of the year and for 2024, since the rate hike phase seems to be largely behind us, while the return on deposits remains unchanged. Alongside this inevitable contraction of net interest margins, there is also the possibility of possible further provision allocations if recession looms. This said, we reiterate our conviction that the momentum in financials will remain positive for a few months yet, before finally normalising. Fears about the repricing of funding and the cost of credit are understandable in light of the sector’s outperformance since the beginning of the year, but we believe that they shall remain unfounded, at least in the short term. However, in the medium to long term, it is reasonable to assume that market preferences will shift to other sectors, but this will only happen with improved visibility on the macroeconomic cycle.

Commentary by Massimo Trabattoni, Head of Italian Equity.