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Morgan Stanley -Changing Guard

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Italy and the Political Cliff (Part IV)

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									FEBRUARY 25, 2013

Italy and the Political Cliff (Part IV)
Changing Guard?
                The first indications, with 55% of the votes counted so far in the Senate, point                                                  Morgan Stanley Research
                 to a great degree of uncertainty, with the centre-right and the Five Star
                 Movement having performed better than expected. While a Bersani-Monti                                                             Europe
                 alliance that should ensure an absolute majority in the both chambers is                                                          Morgan Stanley & Co. International plc+
                 possible, we do not take this for granted.

                As such, compared to more uncertain options, a Bersani-Monti alliance could                                                       Subscribe | Unsubscribe
                 present a positive outcome in the near term, given the parties have declared
                 their commitment to fixing some of Italy’s structural problems. Conversely, we
                                                                                                                                                   Economics, Strategy & Banks
                 would view an uncertain situation, perhaps leading to new elections in a few
                 months, as negative.                                                                                                              London
                                                                                                                                                   Morgan Stanley & Co. International plc+
                But such a fragmented and heterogeneous parliament points to a degree of
                                                                                                                                                   Daniele Antonucci 
                 political fragility. We’re cautious about Italy’s ability to implement deep                                                       +44 (0)20 7425 8943
                 reforms, and think that such risk is underappreciated in the market. This note
                 also looks at the implications across asset classes and banks.                                                                    Francesca Tondi 
                                                                                                                                                   +44 (0)20 7425 9721

Economics (Daniele Antonucci)                                                                                                                      Elaine Lin 
                                                                                                                                                   +44 (0)20 7677 0579

What to Watch Now                                                                                                                                  Hans Redeker 
                                                                                                                                                   +44 (0)20 7425 2430
What’s going on: With 55% of the votes counted so far, the election outcome is far from final.                                                     Graham Secker 
Yet these preliminary indications, if confirmed, suggest either a very fragile Bersani-Monti                                                       +44 (0)20 7425 6188
majority in both chambers or a fragmented and heterogeneous parliament, potentially pointing
                                                                                                                                                   Jackie Ineke 
to a degree of political fragility and indicating the possibility that nobody secures a majority.                                                  +41 (1)44 220 9246

What’s a positive scenario? Everyone would of course prefer a blue-sky scenario with a                                                             Muriel Perren 
                                                                                                                                                   +44 (0)20 7677 1238
strong and stable government capable of implementing substantial structural reforms over a
short timeframe. But the reality is that, among the feasible scenarios, a positive one would
include a victory of those ahead in the polls, who seem committed to fixing, maybe not very
                                                                                                                                                   Elaine Lin, Hans Redeker, Andrew
quickly but perhaps steadily, some of Italy’s problems. Thus, a Bersani-led government, with
                                                                                                                                                   Sheets, Jackie Ineke and Muriel
(i.e., an alliance is needed) or without Mr. Monti (i.e., Bersani has a majority of his own) is
                                                                                                                                                   Perren are Fixed Income Research
likely to be taken positively by market participants.
                                                                                                                                                   Strategists and they are not opining
                                                                                                                                                   on equity securities. Their views are
Possible Bersani + Monti Majority with 55% of the Votes Counted in the Senate                                                                      clearly delineated.
                                     Lower House                                                          Senate
                 Possible Distribution of Seats (% of Total)                          Possible Distribution of Seats (% of Total)


                        5.4                                                                 4.7
                 10.2                              PD-SEL-Other Centre-Left           9.1                              PD-SEL-Other Centre-Left
                                      32.9                                                               32.7
                                                   PdL-LN-Other Centre-Right                                           PdL-LN-Other Centre-Right

                                                   5-Star Movement             24.0                                    5-Star Movement
          25.8
                                                   Monti                                                               Monti


                              25.7                 Other                                                               Other
                                                                                                  29.5




Note: First preliminary results for the Lower House. Source: Italian Government, Morgan Stanley Research


MS CONFERENCE CALL - ITALIAN ELECTIONS: INITIAL REACTIONS
Monday February 25th @ 7:00pm UKT
All participants MUST register using the URL below
(NB: If you get a security certificate prompt, just click straight through):
http://emea.directeventreg.com/registration/15280546

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that
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+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject
company, public appearances and trading securities held by a research analyst account.
What’s a negative scenario? There are various possibilities. First, a very fragmented
parliament where the centre-left performs poorly and the centre-right more strongly than
expected. Second, an unstable coalition where the junior partners closer to the extremes of the
political spectrum gain more than expected (e.g., far-left SEL). Third, a strong result of parties
likely to pursue populist policies (e.g., far-left Five Star Movement, M5S). Of these scenarios,
the rise of the M5S beyond expectations of a 15% gain is an important risk (partial count
suggests more than 20%).

Key signposts: To gauge whether Italy is heading towards a more or less benign outcome,
the focus has to be on the Senate, where the outcome is far from clear. In the Senate, it’s
important to see who is winning the big and uncertain regions, from Lombardy to Sicily and
Campania, where a win for the centre-left would give it an absolute majority, given that most
other regions apart from Veneto are likely to go to the centre-left, according to the polls.

Focusing on the Senate … Even though the polls suggest that a centre-left majority in the
Lower House is possible, the situation in the Senate is a lot more uncertain. The current
system assigns a substantial premium to the winning coalition, which, in a sense, favours
political stability, but only – or more easily – in the Lower House (see Italy and the Political Cliff
(Part III) – Last Minute Q&A, February 18, 2013). So, the chamber to watch is the Senate,
where the situation is a lot less clear. The majority premium is assigned on a regional basis
there, with the regions yielding a different number of seats based on their population.
Depending on which regions are won, the absolute majority might be stronger or very weak,
and there’s even a risk that nobody secures one.

… and the key regions: While we think that the gap is too narrow to call the outcome, the
latest indications suggest that the centre-right is slightly ahead in some of the key regions,
including Lombardy. If the centre-left has to have an absolute majority in the Senate, it can
only afford to be defeated in Lombardy. In that case, winning all other regions would give it an
absolute majority anyway. At this stage, pollsters’ projections suggest that such a scenario
would be a stretch. If, on top of Lombardy, the centre-left is defeated even in just one of either
Veneto (where the centre-right is ahead) or Sicily (where the situation is more uncertain), it will
not have an absolute majority.

Key risks: We’re watching four main factors:

1. The risk of ‘fringe’ parties: One example is the far-left Five Star Movement (M5S), which
is likely to play a key role as an opposition party in the next parliament. With over 20% of the
vote and possibly enjoying rising support according to the partial indications from the vote
counting, compared to the average of all the latest published polls before the cut-off date of
February 8, this appears to be Italy’s third-largest party, even ahead of those supporting Mr.
Monti. Should the M5S gain even more momentum, it might increase the risk of an excessively
fragmented parliament.

2. The number of undecided: It seems that over one-quarter of Italian voters were still
undecided or not planning to vote in the two weeks prior to the election. That’s a big swing
factor, and could determine the outcome of the election. In previous elections, part of the
undecided opted for one of the large parties close to the date, rather than dispersing the vote
in a myriad of smaller parties (the so-called “useful vote”). 75.16% voted in this election,
compared to 80.67% in the previous one. With the vote counting still ongoing, the behaviour of
the undecided is an important known unknown.

3. How Mr. Monti fares: To qualify in the Senate, a party has to get more than 8% of the
votes nationally (while a coalition has to have at least 20%). This is important because there
are four political entities that might pass the threshold and gain seats: centre-left PD-SEL,
centre-right PdL-NL, far-left M5S and the centrist list carrying Mr. Monti’s name. This means
that if a party/coalition is defeated and doesn’t get the majority premium, i.e., if it ends up being
the second largest party in a particular region, then it might lose more seats compared to a
scenario where there were, say, only two parties/coalitions. In turn, this means that one has to
win in virtually all regions, certainly in most of the large ones. But if Mr. Monti doesn’t fare well
in the election – perhaps because the M5S ends up faring better than expected – then Mr.
Bersani will only be able to count on the hypothetical support of fewer Senators from Mr.
Monti’s group than initially envisaged, thus risking having a very fragile majority.

4. ‘Grand coalition’: Should a political gridlock emerge, with nobody being able to muster an
absolute majority, then an alternative to new elections – for which there’s little appetite at this
stage – is a very broad coalition ranging from the centre-left to the centre and the centre-right.
Given that no political leader would likely be prime minister in this hypothetical case (as the
others would oppose such a choice), some sort of technocratic government would have to be
formed. Mr. Monti’s role, given that now he plays an active political role, would remain to be seen
in this scenario. We think that a ‘grand coalition’, being so diverse, would unlikely be very stable.
What Happens Next

Key steps: There are three important phases Italy needs to go through before the new
government can start focusing on policy:

1. Prime Minister nomination: In Italy, the Prime Minister is nominated by the President of
the Republic (Giorgio Napolitano) after having talked to the chiefs of the various parties
represented in the parliament. This is likely to take more or less the whole of this week and
perhaps part of next.

2. Cabinet formation: The ministers are proposed by the Prime Minister, but they too are
formally nominated by the President. This is likely to happen next week.

3. Confidence vote: After the nomination, the cabinet is sworn in and, within ten days, has to
seek the confidence of the parliament, which will reopen in mid-March. One of the first tasks is
likely to be the election of the next President of the Republic before the deadline of May 15.
Is there a risk of a hung parliament? This seems unlikely to us. If the lead of the main
centre-left party (PD) turned out to be insufficient, it might eventually form an alliance with
Monti’s ‘coalition’. Yet the risk is that a coalition this broad, should it happen, might be quite
heterogeneous and somewhat unstable, even though it might convey a sense of continuity to
international investors (with Mr. Monti playing an active role). More broadly, the composition of
the coalitions might be important too, with investors probably thinking that viewing a coalition
where the main party gains the most seats is as more stable.

What to Watch Later

The reform path … Even though fiscal policy is likely to stay prudent and the reform agenda
should continue at a moderate pace, from a medium-term perspective the most pressing
question is whether Italy will be able to strengthen its economic fabric. In turn, the willingness
or ability to maintain a sound reform path crucially depends on the outcome of the election. We
expect further product market liberalisation and some privatisations, but slower progress on
the labour market. While we believe that some important non-economic reforms, e.g., justice
system (over time and to an extent) and public administration, might be implemented, we’re
cautious on the overall pace of reform in Italy. Above all, addressing Italy’s structural problems
is what will determine market participants’ views on Italy’s next political leaders.

… and why it matters: The scar left by the recession is likely to have damaged the supply
side of the Italian economy, thus further lowering one of the slowest paces of potential growth
across DMs – to 0.5% or so. Mr. Monti has implemented various structural reforms, but they
haven’t reached ‘critical mass’. They are a step in the right direction and, if further pursued,
might eventually pay off (see Italy: Good Student, Good Grades? September 24, 2012). This is
an important point because, without a stronger economic fabric, the key factor that might affect
Italy’s growth path is… luck! This is because any shock, be it external (FX, commodities, etc.)
or internal (policy mistake, excessive tightening, etc.), will likely impact Italy more than other
countries, and leave it with no tool to cushion the downturn. With no macroeconomic levers
(being part of the eurozone) and fiscal policy likely to remain tight under most scenarios, the
only viable alternative is to boost long-term growth and resilience via microeconomic reforms.

Rates (Elaine Lin)

1. BTPs have traded closely in line with systemic risk, despite upcoming elections:
Since Mario Monti’s resignation in December 2012, markets have been rather complacent
regarding when political risk resurfaced in Italy. Idiosyncratic underperformance in the BTP
market was very short-lived: and BTPs have traded in line with systemic risk (exhibit S1)

The strong correlation between the performance of BTPs and systemic risk has led BTPs to
benefit substantially from the ‘magic’ of the OMT and spreads have tightened towards our bull
scenario target for the year. At the same time, technical factors such as returning investors
and lower bond issuance have helped to maintain the positive momentum in BTPs. The quality
of the tightening has also been comforting, as it has been accompanied by falling volatility.
2. The current valuation of Italy versus Germany is in line with our baseline scenario, we
believe. An outright majority for the Centre Left would allow BTP spreads to return to their
lowest levels of 2013, whereas a weak and unstable coalition could see spreads return to their
post-OMT wides.
The base case: This looks a bit less likely following the projections (i.e., Bersani coalition with
Monti, meaning that policy is not likely to take a ‘U-turn’) and would be in line with our bull case
scenario published at the end of last year, which puts the 5-year Bund-BTP spread at 265bp,
pretty much on top of where it is currently trading.
The bull case: An outright majority achieved by the Centre Left party would be a still more
bullish scenario for the markets, raising expectations of greater political stability. BTPs could
return to their richest levels of this year, with the 5-year Bund-BTP spread at 225bp.

The bear case: The scenario of a very weak and unstable coalition would have negative
implications for policy implementation going forward. However, the credible backstop of the
OMT should keep the market supported to some extent, led by the front end, whilst the longer-
term policy uncertainty should have a more negative impact on the back-end of the BTP curve.
This should potentially bear steepen the Italy-Germany curve, and the 5-year Bund-BTP
spread should return to its widest levels since OMT was promulgated in September 2012, at
about +350bp.

BTPs Trade Closely with Systemic Risk

                    600                                                                      -3


                    500
                                                                                             -2




                                                                                                  Systemic Risk (PC1)
                    400
      Spread (bp)




                                                                                             -1

                    300
                                                                                             0
                    200

                                                                                             1
                    100


                     0                                                                       2
                     Jan-11 Apr-11   Jul-11    Oct-11 Jan-12 Apr-12 Jul-12   Oct-12 Jan-13
                            Italy vs Germany                     Systemic Risk - PC1 (RHS)

Source: Bloomberg, Morgan Stanley Research


Equity (Graham Secker)

We are overweight European equities: We expect improving global economic growth and a
moderate pick-up in equity inflows to lift markets higher on a 3-6 month view. However, in the
short term we believe that markets are due for a period of consolidation post strong gains and
with investor sentiment relatively elevated. In addition, we believe that the macro newsflow has
been less supportive for equities recently, for example energy prices are now at levels that
have traditionally led to weaker equity performance and European earnings revisions have
fallen sharply year-to-date.
We see very little scope to raise our EPS growth forecast of +5% this year: So further
material upside from here will need to come from multiple expansion. Currently the 12m PE for
MSCI Europe is 12, which is consistent with our base case valuation assumption. While we
could potentially raise this forecast at some point, we are reluctant to do so at this time given
the weaker macro newsflow and a number of near-term risks. The latter include US and EU
politics as well as any renewed growth disappointment in Europe or the US (where fiscal policy
is tightening).
Negative case i.e. Bersani fails to get control of Senate: It is likely that we would see some
downward pressure on Italian equities; however, we do not believe it would lead to wholesale
declines in the wider European equity market unless we saw a big and durable rise in
peripheral bond yields more generally. Nevertheless, the uncertainty created would likely add
to near-term pressure on the market, and we could see Europe's 12m PE move back down
towards 11x, with declines likely led by Financials.
Positive case i.e. Bersani / Monti alliance controls the Senate: In our opinion, the market
does not appear unduly concerned around this election and hence we believe the scope for a
positive reaction to the positive scenario is limited in anything but the very short term – this is
consistent with the view from our interest rate strategists, who do not foresee a big rally in
Italian bonds in this situation.
What our Country Rotation Model says: Although we highlighted the periphery to
outperform the core as a potential ‘key surprise’ for 2013, we have been recommending a
neutral position on this trade so far. Rather, we have preferred to look for relative trades within
these two ‘blocs’, for example favouring strong core countries over weak ones and the same in
the periphery. In effect, this means we recommend investors are overweight Germany versus
the likes of the Netherlands and France within the core and, in the periphery, a preference for
Spain over Italy. While we think these trades make logical sense from a top-down perspective
they also fit with the message from our Country Rotation Model – Germany ranks #3, Spain
#4, France #9, Italy #14 and the Netherlands last at #16. Neither the above positive or
negative case scenarios would likely make us switch our peripheral preferences in favour of
Italy as we do not believe they would lead to a meaningful increase in structural reforms, which
have been more limited in Italy than other peripheral countries.
Italian Bank Equity (Francesca Tondi)

Political uncertainty following the elections remains a key risk and driver of stock prices, as
indicated by the fact that Italian banks have underperformed the SX7P by c. 1% in the last
month, with such uncertainty having increased (despite the fact that the BTP has remained
relatively stable). Indeed, there was an initial strong positive reaction to the exit polls this
afternoon, which indicated a clear win of the Centre-Left; within the first our of trading after the
polls release, Italian banks were up c. 5% and the European banks sector up c. 1%. This was
quickly reversed as soon as the initial count indicated quite a different possible outcome, at
least for the Senate, with the possibility of a hung parliament or even a victory of the Centre-
Right.

The elections outcome remains key for the banks to the extent that it impacts the spreads of
the sovereign bonds, which in turn impact cost of equity, cost of funding and thus banks'
valuations, as correlation to the sovereign remains high. As mentioned in our previous
research (December 11, 2012, Italian Banks: The sovereign/bank feedback loop still painful) a
100bp fall/increase in the BTP spread would impact our valuation for our universe by c.10%
(up/down as there is an inverse correlation, and more for the smaller names).

The base and bull case: We believe an election outcome with a clear majority of the Centre-
Left or a coalition that ensures political stability would be positive for the stocks, as this would
remove a key uncertainty, although macro data and asset quality trends also remain key
factors which impact earnings. In these more constructive cases, although all banks would
initially benefit, we would be selective and would choose UCG (OW) as our preferred play as
indicated in our recent note (January 23, 2013, UniCredit S.p.A. (CRDI.MI): A play on Italian
recovery, CEE, & restructuring - OW).

The Bear case: We believe an unclear outcome following the election, with the possibility of a
hung parliament or even a risk of further elections in a few months, could present a negative
event for all Italian banks, at least in the short term (and one that could also have some
negative impact at European banks level). This might especially be the case if it were to cause
a widening of the BTP spread towards the 350bp level, the widest levels since the OMT was
promulgated, as indicated by our Interest Rate Strategy colleagues. Resurgence of political
risk could also mean a more intense correlation of all Italian banks to the sovereign, in our
view, as witnessed in the recent past.

Italian Bank Credit (Jackie Ineke, Muriel Perren)

How we’re positioned: We have had a strong preference for large-cap Spanish banks
(BBVA, Santander) over their Italian peers (Intesa, UniCredit) since November last year. This
is based on stronger fundamentals at the Spanish banks, with better earnings potential,
diversification and asset quality in our view. We especially like playing this relative value theme
in senior cash and CDS (see Peripheral Banks Review: Preferring Spain to Italy, November
29, 2012). We are happy to stay positioned as we are post the elections, as we believe
valuations do not accurately reflect these credit differentials at present and we expect
fundamentals in Italian banks to further deteriorate versus Spanish banks, irrespective of the
election outcome.

Large-Cap Spanish vs. Italian Banks: Trade Ideas
B/O   Type    CCY     Ticker      Cpn     Maturity    Amt o/s (m) Price   Z-to-M   YTM
B     Snr    €       UCGIM        4.375   11-Sep-15      1,350   105.31   161      2.2
O     Snr    €       BBVASM       4.375   21-Sep-15      1,500   103.21   246      3.0
B     Snr    €       ISPIM        4.875   10-Jul-15      1,000   105.65   182      2.4
O     Snr    €       SANTAN       3.381   1-Dec-15       1,198   101.39   223      2.8
O     Snr    €       SANTAN       4.625   21-Mar-16      2,600   104.02   256      3.2
Source: Morgan Stanley Research


FX (Hans Redeker)

The Italian election has been a key risk for FX markets. This uncertainty has increased
even further with the initial exit poll results. Our base case scenario remains a Bersani-Monti
coalition and, should this come to fruition, we would maintain our call for a EUR overshoot to
1.38/1.40 over coming months. But to the extent that outcome in the Senate is more
fragmented we would become more cautious on EUR.
A Bersani-Monti coalition could present the more market-friendly outcome, in our view. We
think markets may take the involvement of Monti in the coalition as a positive, given the
reforms he has been able to push through over the past months, and this should keep
sovereign spreads capped, supporting renewed inflows into EUR assets.

However, there are significant risks to this base case. A fragmented Italian parliament could
lead to an initial EUR decline, with the medium-term path to be determined by the ability of
parliament to form a functional government, that, if needed, will be able to agree on and
implement the conditionality necessary for access to the OMT. So long as OMT access
remains a possibility, we would expect EUR declines to be somewhat limited. However,
should there be a failure to reach any sort of political consensus, OMT support would be
viewed as inaccessible, as politicians would be unable to commit to the necessary
conditionality for the ECB to commence purchases. In this case, the EUR would enter a
deeper decline over the medium term, in our view.
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Francesca Tondi, Elaine Lin, Graham Secker, Andrew Sheets, Jackie Ineke, Muriel Perren.
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                           Coverage Universe    Investment Banking Clients (IBC)
                                          % of                   % of % of Rating
Stock Rating Category         Count       Total     Count Total IBC Category
Overweight/Buy                1040       36%          400       39%         38%
Equal-weight/Hold             1278       44%          483       47%         38%
Not-Rated/Hold                 106        4%           27        3%         25%
Underweight/Sell               479       17%          108       11%         23%
Total                           2,903                      1018


Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual
circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan
Stanley received investment banking compensation in the last 12 months.
Analyst Stock Ratings
Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe,
on a risk-adjusted basis, over the next 12-18 months.
Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage
universe, on a risk-adjusted basis, over the next 12-18 months.
Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's
industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe,
on a risk-adjusted basis, over the next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant
broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad
market benchmark, as indicated below.
Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad
market benchmark, as indicated below.
Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index;
Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
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