Above the noise: Why is Italy still being punished?

By accident really I recently came across the economic forecasts for Italy and was actually struck by what I observed - especially given the context of the current level of Italian government bond yields. Alas, this is not a long indepth analysis but merely a string of observations which hopefully encourage more investigation, deeper thought and perhaps alternative investment decisions.

Without hesitation most investors claim that Italy is a 'problem country', much like Spain, Ireland, Portugal and Greece (combined constituting the commonly referred to PIIGS constellation). But, if you look at the forecast for budget balance as a percentage of GDP in 2012 and 2013 then Italy ranks second, only surpassed by Germany. Who would have thought that?

The next interesting observation is that both Italy and Portugal seem to be paying a relatively higher interest rate on 10-year government bonds than other countries with projected budget deficits. I believe most would be surprised to see this large divergence.

It is rarely the case that the media focuses on 'good' news in the Eurozone. Not much has been said about the fact that Ireland is soon returning to the bond market as an issuer of government debt securities. Italy's technocratic government has actually implemented reforms with broad support secured from political opposition parties and the population in general, but again not much credit has been given for this. Nevertheless, the string of reforms in Italy is paying off, judging at least by the change in the 2012 forecast for budget balance as a percentage of GDP (see chart below). It seems to me that Italy is on the right track compared to say Spain.

Given all of these positive observations why then is Italy paying 6 percent on its 10-year government bonds? My view is that Italy, to a large extent, is still being grouped in the same basket as Spain, Ireland, Portugal and Greece - albeit judging by the numbers alone its place should perhaps instead be filled by France.

Without indulging in fantasy alone there are however some key problems causing pressure on Italian bonds. One is the Italian banking system and herein lies the ultimate trigger for a potential bailout - similar to what happened in Spain. Another problem is Italy's debt-to-GDP ratio which is among the highest in Europe. But should that really be a major concern considering that most government debt is normally rolled (often because of investment mandates on pension and insurance companies) and given that the budget deficit is narrowing and debt servicing is improving? Also a majority of Italian debt is domestically owned - contrary to French debt - making it more stable.

Should the perception of Italy change and the pressure on its banks ease then FTSEMIB and Italian government bonds could be good short-term investments.