Finance & economics | Buttonwood

Italy is central to the bull case for euro-zone stockmarkets

Might there be a Draghi effect?

PITY THE broker of European shares. He spends his afternoons making calls to investors in America. Few are returned. His clients are tired of Europe and its vaccine snafus. Even a good-news story, such as Mario Draghi becoming prime minister of Italy, has little traction. Italy is central to the fortunes of the euro zone. Mr Draghi is a reformer to be reckoned with. But a lot of people think the country cannot be fixed. “If God descended from heaven and became Italy’s prime minister,” says a hedge-fund boss, “the market still would not rally.”

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The story of 2021 is that America’s economy is reopening with a bang. By comparison, everything in Europe looks sluggish: GDP growth, the roll-out of vaccines, the deployment of fiscal policy, slow-moving companies, and so on. That lack of urgency extends to the stockmarket. Europe has no FOMO (fear of missing out), says Graham Secker of Morgan Stanley, a bank. It is wholly lacking in the froth so evident in America. Yet that is probably a good thing. Because—whisper it—so far this year the euro-zone stockmarket has managed to keep up with America’s.

Among non-US stocks, the euro area looks attractive on a price-to-earnings basis, says Mr Secker. The perennial appeal of Europe is that it is cheap. That is not always, or even usually, decisive in stock investing. (Cheap for a reason, sneer the sceptics.) But since November, when news first broke of an effective vaccine for covid-19, “value” stocks (ie, those with a low price relative to earnings or book value) have generally done better than “growth” stocks, their antithesis. This rotation towards value ought to favour Europe, where bourses are crammed with cheap-looking banks, widget-makers and commodity firms, the sort that tend to do well in periods of reflation, such as now.

Investors looking for deep value could do worse than consider Italy. In any event, if you take a punt on the euro zone, you are in effect taking a punt on Italy. Its stockmarket is more European than most. It is chock-full of energy and financial companies, the kind that have been out of favour with investors until recently, and of which Europe has lots. But this is about more than just the make-up of its stockmarket. Italy is the weakest big economy in continental Europe, itself a locus of weakness. If Italy can do better, then there is upside for the region as a whole.

Enter Mr Draghi. He is not quite a deity, though he came close to being one in his euro-saving eight-year stint as boss of the European Central Bank. Last month he was asked by Italy’s president to form a government. Parliament quickly fell in behind him. He has since set out some broad reform goals: to fix Italy’s tax code, its sclerotic bureaucracy and its sluggish courts. Each is a bar to enterprise and a stronger economy. Mr Draghi has picked the right spots and is the right man to tackle them. But after an early burst of euphoria in Italy’s markets, doubts have crept in. A big one is that his time as prime minister is likely to be short-lived. There is also the question of whether a few bits of legislation can make a difference. Italy is a low-trust economy. This is reflected in the ubiquity of small family firms. An array of restrictive practices is hard-wired into its society. Changing all this quickly is not easy.

Still, you have to start somewhere. A big problem is the difficulty of making business agreements stick. It takes more than twice as long to enforce a contract in Italy than in France or Germany. A better functioning judicial system is the foundation on which a broader construct of trust might be built. Italy’s tax system is complex and discourages job creation. A little judicious reform might go a long way in improving incentives to work. And in his efforts to cut red tape, Mr Draghi can already point to progress. On March 10th Italy’s three largest union federations signed a pact agreeing to reforms of the government bureaucracy. This is a small start. But it speaks to a shift in the mood in Italy.

Mr Draghi has the advantage of being able to offer goodies in return for painful changes. Italy will be the largest beneficiary of the €750bn ($900bn) EU recovery fund, the disbursements of which are tied to progress on reforms. This is not quite Joe Biden’s $1.9trn mega-package but it is not nothing either. A lesson from the 1990s, when Italy strove to qualify for the euro, is that reforms can happen if Italians can see a payoff from them. This is a hard story for a broker to sell given the latest vaccine mishaps. Europe is the opposite of a meme stock. But right now, that might actually be a plus.

This article appeared in the Finance & economics section of the print edition under the headline "The Draghi effect"

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