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Traders brace for more turmoil in world's worst equity market Italy

[ZURICH] While most western-European markets have recovered from the Brexit shock, Italy still has a long way to go. With a looming referendum and an ongoing banking crisis, traders are paying up to hedge against more stock turbulence.

Investors in the Mediterranean nation, already suffering the world's biggest losses this year, are bracing for a vote on political reform expected in November that could decide the fate of Prime Minister Matteo Renzi. 

They have pushed the price of options protecting against volatility in Italian equities for the next three months to the highest since 2013 versus shorter- term contracts, according to data compiled by Bloomberg.

Citigroup Inc has branded the plebiscite the largest risk in European politics this year outside the UK.

Italian banks are also suffering as they scramble to shore up capital in the face of 360 billion euros (S$543.8 billion) of bad debt.

For Kevin Lilley, a manager of euro-area equities at Old Mutual Global Investors in London, the danger is so high he cut his Italian holdings to just one company - defence firm Leonardo- Finmeccanica SpA - after selling shares including Banca Popolare di Milano Scarl and Mediobanca SpA.

"Italy has been so oversold in the last year because of the political uncertainty," said Mr Lilley, whose firm manages about US$34 billion.

"The referendum is a completely binary event, it's a very good thing for Italy if it's passed because it simplifies the decision-making process. But unfortunately the prime minister has tied his future to the result and banking problems are still in the background."

Last year, when a China-led selloff erased as much as US$8.3 trillion from global equities, Italy bucked the trend.

The benchmark FTSE MIB Index reached a near six-year high in July 2015, and surged an annual 13 per cent, as an overhaul of employment laws and expectations of a domestic economic revival buoyed investor confidence. This year, the equity benchmark has slid down the rankings, and one of the biggest exchange-traded funds tracking the market is heading for a seventh month of outflowsin eight.

Italy's banks are leading losses among European stocks amid concern over their levels of bad debt.

Banca Monte dei Paschi di Siena SpA, which fared the worst among 51 of its peers subjected to recent European stress tests, has plummeted 80 per cent in 2016 as its plan to offload billions in doubtful loans and increase capital failed to win over investors.

Unione di Banche Italiane SpA, which has fallen 62 per cent this year, earlier this month reported a second-quarter loss on higher bad-loan provisions and restructuring costs.

The economic picture offers little comfort: Italian growth unexpectedly stalled in the second quarter, missing forecasts for a 0.2 per cent expansion. The Bank of Italy and the International Monetary Fund have both lowered their projections for the year, predicting an expansion of less than 1 per cent.

But, after a slide of 22 per cent this year for the FTSE MIB, Jasper Lawler, a London-based analyst at CMC Markets, said that some investors may see an upside: valuations on Italian stocks have fallen to about 13 times their estimated earnings, near the cheapest in four years versus the Stoxx Europe 600 Index.

"The referendum doesn't deserve the kind of concern it has generated," he said. "Italy is arguably behind the curve with the reforms, but this referendum is part of Renzi trying to catch up and do some things. It's a question of whether you want to go with the momentum or value."

Still, the valuation case may not be compelling enough to attract investors focusing on banking woes and the potential ramifications of the referendum. Ratings company DBRS, which is used by the European Central Bank for grading collateral for its liquidity operations, said on Aug 5 that it was reviewing Italy's credit score, citing political risks and the "fragile recovery."

"There's the banking issue and then the referendum issue," said Thomas Haerter, chief investment officer at Zurich-based consultancy firm Wellershoff & Partners.

"It's difficult to see why stocks should perform without earnings normalisation - we have sluggish growth and low interest rates, so even if you have a credible bank bailout you are still left with a profitability problem. It's a mess, and it's difficult to see the way out."