Italy outperforms Spain - PM Monti suddenly the good guy?

Can investors and the media only handle one topic at a time? On virtually every media's online or offline front page we see Spain’s PM Rajoy. He did make a huge political stumble on March 2 with an expectation of a deficit of 5.8 percent, which was a big miss on the deficit target of 4.2 percent agreed to with the EU, and this has since stolen all the headlines. But where is Italy’s PM Monti in all this? Did he just fix the engine and so all is fine in Italy? Is this simply the reason behind Italian stocks' outperformance of Spanish stocks by almost 6 percent (see chart 1) since early March?

Should investors just simply sell IBEX and buy BIC30 or something similar to the Italian index?
I see some of the Italian outperformance caused by investors hedging their Spanish exposure by selling the IBEX index without really knowing what is actually inside the index - see Like riding a Bronco for insight. The underperformance has escalated lately while more and more news is centred on Spain. Italy has underperformed Europe, but not to a great extent.

Before investing in any index, especially the more concentrated (30-50 stocks), it is advised that investors look into what companies are included and therefore what business cycle and drivers are moving the index.  Yesterday I looked at IBEX and analysed this and made some conclusions based on this. Doing a similar exercise on Italy’s BIC30 also reveals some interesting things.

BIC30 sector weights
Looking at chart 2 you see that finance/banks is also a dominating sector in BIC30 as is the case for IBEX. The weighting is dominated by Unicredit (CRDI, Intesa Sanpaolo (ISP) and Generali (GASI) all with weightings in the 5-6 percent range. The second-largest sector is energy minerals with a 22 percent weighting which is substantially different from IBEX, and even more important it constitutes just one stock - ENI (ENI)!

By a margin, Industrial Services is the third-largest sector which has a low weighting in IBEX and the fourth sector is utilities which has a weighting just short of 15 percent.

Reflections
From my point of view it would be a mistake to interpret financial exposure in the two indices as “equals”, even if the percentage weightings are alike. One driver (of risk) behind Italian banks concerns refinancing issues in 2012. First of all, are they able to access the financial markets and secondly at what price? Is profitability at risk or at least seen resulting in a very low ROE compared to banks in mainland Europe where refinancing is easier?

Further to this, Italian banks' exposure to Eastern Europe is the main risk. My colleague Tomas Berggren described in his post Austrian banks exposed to Central and Eastern Europe some of the issues concerning Eastern Europe. Large CEE exposure makes Italian banks vulnerable if the financial deficit problems flair up again. Especially Intesa Sanpaolo has huge exposure towards Hungary and its toggle with the EU at the moment does not bode well and just increases the risk.

The banks in Spain i.e. Banco Santander (SAN) and BBVA (BBVA), are currently mostly concerned about the housing market and deflation of the bubble from 2008. This process is a slow grind and has a huge effect on the overall economy. At the same time the Spanish government is initiating one austerity package after the other which makes the housing situation even more dire. Therefore investors should not just look at the sector weights to finance and make conclusions but rather get a grip on the underlying driving forces.

Finally, large single stock weights in the indices are potential drivers of diverging performance. In BCI the massive weight of the cyclical energy company ENI is very different from the defensive telecom company Telefonica in IBEX. These companies can have huge implications for the performance of the indices and their performance is dependent on which route the global economy heads along.

It seems however as if investors are dumping the defensive Telefonica (TEF) cash flow and switching to a more cyclical energy cash flow, judging by the look of the performance lately on each of the stocks. Telefonica has dropped 15 percent while ENI has risen a modest ½ percent, constituting a huge difference.

Which index will perform?
Both indices have risks associated with the developments in the financial crisis in each country and the developments in Europe. I would take the developments in the Spanish and Italian government 10-year yields as a proxy for this overall development. The yields reflect investors' and creditors' assessment of the credibility of the clean-up process going on at the moment. Are the solutions in total just paving the way to a blind alley or are they really bearing the fruit of a better future? The test is in 2012 and 2013. While sound judgement is out, volatility is in. You will see this reflected in the stock indices. Now you are hopefully more informed about what drives the BCI30 and IBEX35 so that you can make more qualified investment decisions.

Conclusion
Negative Spanish macro-economic news has undoubtedly taken its toll on IBEX35 but this is not the entire story behind its underperformance vs BCI30. The different drivers of risk and not least the huge exposure towards ENI is a reason for the latest outperformance.

Appendix
Below in tables 1 and 2 supplementary information on the largest weightings in the index are listed. Compare these with tables in the article about IBEX.