http://www.imf.org/external/pubs/ft/scr/2016/cr16222.pdf

Brexit has stirred up a real crisis, but not in the country that wants to leave the EU: it is Italy that’s bearing the brunt of it…

Anyone who thinks that the British stock market has been in the doghouse as a result of the Brexit result is barking up the wrong tree. In fact, as I write, the FTSE 100 is more than 5% above where it closed on 23 June, a time when most people still thought that the British would vote to Bremain. Strange indeed: isn’t Brexit supposed to cause the UK to go into recession? Since when has recession been good news for stocks? It isn’t, I can assure you. And that recession will undoubtedly come.

Stock price movements since 23 June

Source: Robeco, Bloomberg

The fact that the British equity market has performed so well since the referendum result is thanks to a combination of two factors – the massive depreciation of the pound sterling (more than 10% against the euro) and the fact that a large proportion of the revenue (and earnings) of larger British companies are generated overseas. Looking at the top ranking companies in the index, it is clear that the UK plays a pretty small role. HSBC and British American Tobacco for example, you could easily categorize as Asian companies on the basis of where they do business and, of course, everyone knows deep down that Royal Dutch Shell is actually a Dutch company. ☺ If you convert the earnings and revenue generated outside the UK back into pounds, you’ll see that profit forecasts for the larger British companies have suddenly risen. However, if you look at the British midcap index (FTSE 250), where a larger proportion of revenue and earnings originate in the UK itself, then it is clear that the outcome of the referendum certainly has hit British stocks.

But this article isn’t supposed to be about the UK, we were discussing the Italian economy. What the second graph shows is that the Italian market has been hit hardest. In the two days after the Brexit vote, the Italian market fell by a whopping 16% and even now, after two weeks, it still has to erase a loss of 7% if it is to regain its ‘old’ level. The main culprits are the Italian banks, which have fallen a ‘mere’ 30% since the British voters’ decision was announced.

So have the Italian banks got British connections? Have they been speculating on a stronger pound and had their fingers burnt? No, not really. Italian banks have no direct link whatsoever with the whole Brexit affair: the referendum was just an unexpected shock that rekindled speculation on the European banking sector. All European banks came under pressure, partly because capital market rates fell further, but also because the Brexit could lead to a painful unraveling of the European banking sector. And then it’s no real surprise that the weakest link (Italian banks) were the hardest hit.

It is also clear that they really are the weakest link if you look at the graph below. It shows what percentage of the outstanding loans for each country are categorized as non-performing. This term is usually applied to loans that are more than 90 days in arrears on the interest or redemption payments. This graph shows that this percentage, which rose sharply as a result of the credit crisis and the subsequent euro crisis, has since steadily improved in most countries. Italy is the country that deviates most from this pattern: not only was the percentage there historically already higher (5% before the crisis), but there has never been any reduction to speak of. Nor has there ever been any real reorganization of the banking sector. In such cases it’s just a question of time before the fat hits the fire. Brexit was the spark.

Source: Morgan Stanley

Italian economy
But this article isn’t supposed to be about the Italian banking sector either, we were discussing the Italian economy. And so I finally come to the first graph, which comes from a country report about Italy that the IMF actually published this week. Not in response to the developments of the last few weeks, but as part of their periodic assessment of the Italian economy.

The problems of the Italian banking sector (and lack of any action) aside, there is quite a lot wrong with the Italian economy. A high level of government debt, almost no growth in productivity, high unemployment, lack of investment, inflated wage costs and I am not done yet. The point is that this is not temporary weakness – a cyclical dip – it is a structural problem. This is also what the first graph clearly shows: the horizontal axis shows the average GDP growth over the last 25 years, the vertical axis, the growth in productivity over the same period. Italy scores remarkably close to zero. This makes it worse than Greece, while even Japan – always considered a horrifying example of depression and deflation – has performed better over this period.

When it comes to the outlook for the future, the IMF is also far from optimistic. The graph below shows what the IMF expects in terms of growth for the next ten years. On the basis of this scenario, Italy will recover from the economic downturn that started in 2007 in 2024 at the earliest: that’s more than 17 lost years. You should also be aware that this analysis was completed before the results of the British referendum pushed the problems of the Italian banks into the spotlight. But it is difficult to imagine that this will have in any way improved the outlook…

http://www.imf.org/external/pubs/ft/scr/2016/cr16222.pdf

It doesn’t give you much to be happy about. So if you still haven’t decided where to go on holiday this summer, I suggest you choose Italy as your destination – they need all the help they can get.