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Redstone view - Is Italy back in fashion?

Redstone has been thinking about the Italian Italian market a lot more this year and with good reason.

Five years ago, when Draghi said "Whatever it takes" funding costs had climbed to unsustainable levels. At that

point, Italian ten-year debt traded at 7% reflecting, in part, the redenomination risk into local currency. With the ECB effectively acting as the lender of last resort, risk decreased considerably. This active support has reopened the Italian market and lowered the implied cost of funding.

Over time some structural reforms, monetary easing and improved growth have seen funding costs fall offering a real prospect of debt sustainability for the Italian economy. Italian GDP has had positive growth for thirteen consecutive quarters. The OECD projects Italian GDP to continue to grow, by 1% in 2017 and 0.8% in 2018 and we feel they may fall somewhat on the cautious side.  Increasing global demand and the depreciation of the euro are supporting Italian exports. Business investment is strengthening, and although public investment has not yet recovered, there is light at the end of that particular tunnel - More on that below.

The accommodative Eurozone monetary policy has helped to lower interest payments and expand fiscal headroom. Italian fiscal policy is projected to remain mildly expansionary in 2017. The general deficit was 2.4% of GDP in 2016, down from 2.7% in 2015, thanks to lower interest expenditure. In 2017, the deficit is set to decline slightly to 2.2% of GDP. In 2018, if policies don't change the deficit will sligh

tly increase to 2.3% of GDP, due to a lower tax burden. The OECD assumes a fiscal retrenchment of about 1% of GDP in 2018, as required by EU fiscal rules even though the economy is running well below its potential and the recovery is still fragile.

Exports and investment are supporting growth: In 2017, real GDP is projected to grow by 0.9%. Exports are set to accelerate in line with external demand which should see real GDP growth increase to 1.1% as stronger exports, sustained investment, and also we should see more buoyant private consumption, on the back of moderate wage rises.

The political landscape in Italy, as everywhere, is hard to handicap at the moment. Italy’s recent municipal elections, in which more than four million people were eligible to vote to elect mayors in 110 municipalities provided a taste test of what we can expect from the next general election, expected spring 2018. These municipal elections saw centre-right parties making gains with voters shifting away from centre left and populists.  This change is something of a blow to the ruling centre-left Democratic Party (PD) led by Matteo Renzi. Renzi regained the party leadership in late April, but still, faces powerful internal dissent. Centre-right parties also benefited from votes of supporters of the populist 5 Star Movement, which performed less well than expected in the first round of the local elections in June, and was therefore excluded from the runoffs in most of the largest cities.  The results will be interpreted as a call for unity for the centre-right parties. They have been weakened by divisions and a lack of leadership since Berlusconi was discharged from the Italian Parliament.

The risk of an Italian banking event appears to have subsided thanks to state intervention. The rescue of Veneto Banca and Banca Popolare di Vicenza has been agreed with Intesa Sanpaolo acquiring the “good bank.” The state will buy the “bad bank”. EU structures were adhered to, and retail investors were not forced to "bail-in".

We expect Monte dei Paschi to be recapitalised in the summer and Unicredit booked a capital uplift of €13bn selling €17 billion of NPLs to Pimco and Fortress. The Italian banks could divest another €60-70 billion non-perform

ing loans this year. Italian NPL sales in 2017 alone could reduce the non-collectable/total loan ratio from 12.1% (Dec 2016) to 9.8% by the end of 2017. With the European average at 5%, there is still work to do.

The Italian employment market benefitted from a reduction in social contributions made by employers in 2015 and 2016. Italian employment is rising, by 0.7% in 2017 YTD and by 1.0% over the past twelve months and expected to continue to grow in 2018. However, as a result of higher labour force participation, the unemployment rate is projected to remain above 11% over the medium term.

Private consumption growth remains robust despite slowing job creation and modest wage gains.  Inflationary pressures in Italy are likely to remain subdued because of large spare capacity. Inflation for May 2017 at 1.4%.

We believe that some Italian assets and sectors represent good value. We are active in industrial and commercial real estate, particularly prime and super-prime real-estate in Milan and Rome. 

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