The latest news item causing concern for investors in European stocks has been the recent political turmoil in Italy. The country’s political leaders have failed to form lasting coalition governments and unite disparate factions in their electorate for some time now. Yields on Italian sovereign bonds are now spiking, adding to the perception that something is coming to a head.
For us, the weight of the evidence tells us nothing material has changed and to stay the course in terms of our modest overweight to European stocks in our portfolios:
- Political turmoil is nothing new for Italy. The country has had over 60 governments since World War II. One commentator on Italian politics in explaining this turnover says, “Italy’s history of encouraging coalition government, the multiple wings of political parties creating internal conflict, and the country’s relative youth are all factors.” However, it’s true that Italy is much larger and relevant than Greece, which was the center of crisis previously.
- Could Italy leave the euro and is contagion risk again a plausible scenario? Leaving the currency union would inflict a lot of short-term pain on a country—even the populists know that. Yet the possibility of the euro not holding together as some countries leave has been a risk factor we have weighed for many years. In fact, that risk was a part of our thinking behind initiating a Europe fat pitch during the Greek crisis in 2012, which we ultimately unwound nine months or so later with a small tactical gain. That risk continues to weigh on our minds, along with other risk factors: financials, tech sector weightings, etc. This is why our overweight to Europe is modest relative to the opportunity we see there.
- The profit gap between European and U.S. stocks is at historical highs. And we believe this is not yet priced in. From the outset, we’ve believed a tactical overweight to Europe would pay off as this gap declined.
- European companies generate about half of their revenues outside Europe, and they have relatively little trade/GDP exposure with Italy. All this shields to some extent the European companies we are invested with. Of course, we know negative sentiment can make cheap assets cheaper. So, it’s possible we may have to be more patient. This is a point we made in our most recent quarterly commentary too, due to factors other than Italy.
- Italy’s political turmoil may lead to other positives as it relates to our modest Europe overweight. For example, it could lead the ECB to maintain a looser monetary policy for longer; it could cause Europe to take steps to integrate in a way that makes sense rather than this muddling along, which has caused economic and social pain; etc.
—Rajat Jain, CFA (5/30/18)
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