Eurozone Recovery: Italy Follows Spanish Lead

Alice Gaskell: Hi.

Wall: So I thought we'd start with the recent European elections. How exactly did these affect markets, if at all?

Gaskell: There was a huge impact actually on the Italian market. Ahead of the election, there was a lot of concern that the new Prime Minister, Renzi, might not get enough support in what was his first electoral test. We were hoping that he would get around at least 32% of the vote. In fact, he got 41%, which was really one of the strongest mandates for an existing government that we've seen in any election in the last few years. And that's a huge change for Italy, there's a lack of leadership since Berlusconi departed.

We are seeing confidence improve dramatically in the Italian economy anyway, and with that sort of electoral mandate, we think that Italy will move forward to reform rapidly and the economy will beat expectations. The market responded very strongly to that and Italian banks and Italian market was one of the strongest in the week following the election.

Wall: But this is not just a short-term bounce you're saying, this has serious positive long-term implications?

Gaskell: I mean, Italy needs to change. It has been one of the slower countries to respond to the crisis because of the lack of political leadership. They've been watching Spain, I think, and seeing the changes that have been made to labour market conditions, to pensions and tax. And seeing that that's actually having a positive impact – so Spain was upgraded by S&PEurop a couple of weeks ago and it's GDP forecast was also upgraded by S&P – and that makes it hard for Italy not to act now as they have seen that this process really does work.

So I think there was a lot of scepticism on whether Italy was really going to make the changes they need to. Renzi's first focus is constitutional change, and to find a constitutional reform, which allows them to have a government that lasts, and we've seen – we know very well that Italian governments change every sort of year or so. Those things are important, and they have long-lasting impacts.

Wall: As well as the elections, there has been a lot going on actually in Europe at the moment. There have been several measures by the ECB. One of which is the lowering of interest rates. They were low anyway, but they've just sliced another smidge off the top. How does this affect stock markets? If it does affect stock markets, is it by a back route through consumers or is it directly?

Gaskell: I think that Draghi has had a great impact in terms of what he says, rather than what he's done. So we know his speech in 2012 saying he was going to do whatever it takes, led to a massive recovery in the Euro and confidence in Eurozone economies, where he actually didn't really do very much.

I think this was another example of a very well-pitched message to the markets. So, it's a very small cut, and in effect, it doesn't make a lot of difference, but it's a real signal that Mario Draghi wants to really push the financial system to start to lend to the economy.

I just mentioned the confidence is increasing and we are seeing signs of recovery in southern Europe, and Mario Draghi is doing everything that he can to support that in the same way as the Bank of England did a couple of years ago when the U.K. recovery was very fragile.

What we thought was more interesting about what he did a couple of weeks ago was the steps that he took to start direct lending to SMEs across Europe. So, one of the issues that Southern Europe has faced is their credit costs are being very high for small businesses and mid-sized businesses, and these are the ones that employ a lot of people.

The banking system has been slow to start to lend, and Mario Draghi took steps to sort of create a direct form of lending to those kind of entities, which we think will have a real impact on the economy as it starts to come through.

Wall: How do the stress tests that the ECB have proposed for banks fit into all that and indeed have an effect on your fund, because I believe you've massively upped your exposure to financials recently, haven't you?

Gaskell: Yeah. So we did financials through 2011 and '12, when the risks were very, very high both on the economies and on sovereign bonds, which a lot of – the banks in Europe obviously owned, and on the assets and the loans that they had made in the previous five or six years. But at the beginning of last year, we started to feel that the political risks had receded, that there was a coherent political and economic framework for the sovereign bond market, which was stabilising. So we took another look at financials and started to increase our exposures, but not to the banks at that stage.

So we took our exposure from about 5% of the funds at the beginning of 2012 to around 25% today, but largely through what we see as much more – much safer financials, much more visible business models or stable business models, the insurance sector, which offered a lot of yield and was generating a lot of spare capital, but was trading below net asset value at the time. And also the real estate sector, again, very high quality assets, a lot of yield available and would benefit as the Eurozone economy came through.

The banks, we sort of stayed away from because there is still – even now, uncertainty over how much capital they need and uncertainty over the dividends, which a lot of them are paid in shares rather than cash.

Even BNP Paribas (BNP), which is really one of the safest banks now in Europe in terms of its balance sheet and its franchise got hit by the fines that are coming through from the U.S., which may have an impact on their dividend in the short term.

So, we have a few banks. We have started cautiously to add to the banks, but they have tended not to be in the Eurozone. They have tended to be in Scandinavia where the economies are much more robust.

The banks have already built their capital and it's much clearer that they do have spare cash now to pay to shareholders. We haven't yet dipped our toes into the Eurozone banks because we think the AQR that is coming up, and the stress test is still will create risk for our shareholders who are focused on dividends.

Wall: Alice, thank you very much. This is Emma Wall for Morningstar. Thank you for watching.