November 22, 2016 by Jennifer Mersereau
Since the Hamilton Capital Global Bank ETF (HBG;TSX) launched, the ETF has limited its exposure to Italy owing to the banking sector’s significantly higher volatility, as well as HBG’s preference for exposure to European countries with higher/reliable dividend yields (i.e., we favour banks with lower regulatory and capital risk). This limited exposure has been despite Italy being one of the few jurisdictions (the U.S. mid-caps being another) where M&A is expected to be a theme over the next couple of years, and Italian bank stocks generally representing very deep value (albeit with elevated regulatory risk). Below we discuss why we have reduced HBG’s Italian bank exposure further.
The market has contended with no shortage of political uncertainty this year, with the U.K. referendum (“Brexit”) and U.S. election being the most significant. To complete the 2016 political triad, Italy has set December 4th as the date of its constitutional referendum.
Although not an explicit vote on the future of a political party/country, like U.K. prime minister Cameron linked his political future to the Brexit outcome, Italian Prime Minister Matteo Renzi has indicated that he may resign if he is not given a mandate of change – i.e., if “No” wins.
Notwithstanding the heavily-discounted valuations of Italian banks, we have reduced HBG’s Italian exposure to zero at this time (from an already small ~3%) and its overall European exposure to 20% (versus an expectation to hold ~25% of HBG’s net asset value in European banks over time).
Why?
First, although polls have shown “No” with a clear lead for some time and the market has arguably already priced material weakness into Italian bank stocks, we believe the secondary effect of a “No” outcome is still a significant unknown. Should Renzi resign, several outcomes are possible, including a caretaker government but also early elections (Italy is currently expected to hold its next national election in early 2018). Early elections could see the “euro-skeptic” Five Star Party make meaningful inroads (if one still trusts polls).
Second, European banks have generally had a strong rebound since Brexit (Italian banks being an exception), with both the SX7P (European banks) and the SX7E (eurozone banks) indices up 32% through Monday (since the Brexit reaction lows set on June 27th). With such performance, European banks could be set for a (short-term) pause, particularly in the event of any increased uncertainty.
The ultimate tail risk is the referendum puts Italy on a road to exiting the eurozone. While politics are always difficult to predict, a significant number of steps would have to take place, over a number of years, before Italy actually took that path. Hence, we believe this potential outcome remains – for now – a very low probability event. Nonetheless, in the short-term, we prefer to reduce risk for HBG and await the referendum outcome before re-evaluating.
Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.