Italian Shares are Galloping. How Long?

Italian shares have been on a tear. In dollar terms, Italy is the top performing developed equity market this year and the best performer over the past twelve months. But investors would be right to wonder how much upside might be left.

The MSCI Italy equity index is up 15.5% in the year to date and up 51% over the past 12 months. Perhaps unsurprisingly, the Italian market’s closest rivals are Ireland, which runs a close second on the year-to-date performance, and Spain. Unsurprising because the equity market performance follows a general turnaround in sentiment about the euro zone’s prospects.

Ever since European Central Bank President Mario Draghi said he would do “whatever it takes” to ensure the single currency’s survival, sovereign debt yields have been plunging across the single currency region. And as those yields fell, equities rose.

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The latest spur has been a revival in euro-zone banking stocks. Overall, the single currency region has a substantially higher weighting in banks than, say, the U.S.. During the financial crisis, this caused euro-zone markets to underperform. Now their rebound is helping to do the reverse.

It’s notable that Italian banks have been among the major drivers of European equity gains recently. Investors are increasingly confident that Italian banks are managing to recapitalize sufficiently while optimism about the state of the Italian economy is also picking up. Recent business surveys have pointed to moderate growth.

But how much more upside is there?

Italian bond yields have collapsed to where they’re close to all-time lows. Yes, the differential between Italian and German bonds still has a way to go to get back to where it was in the years before the financial crisis. But that seems unlikely.

The ECB’s promise to save the euro doesn’t extend to guaranteeing that bond investors will never face credit risk–as Greece showed, euro-zone governments can default and still manage to stay in the single currency.

And Italy has a very considerable debt load–only second to Greece’s at 132% of GDP. Yes, the Italian government is making strides to balancing its books. But the economy is also facing a long struggle against demographic pressures–Italians are nearly as old, on average, as the Japanese.

Yes, there is potential to extract more economic potential out of structural change, especially of the government. But Italy has been promising political reform for decades and yet delivered little. So Italy’s overall growth prospects are bound to remain modest.

Italian equities may well have further upside. But the prospects for outperformance are diminishing.