LONDON/MILAN (Reuters) - Italian stocks are trading at the biggest discount in 35 years to stocks globally, given investors' fears about the fiscal outlook for one of Europe's most indebted economies, although some believe stocks are too cheap to ignore.

Although Italian equities have historically been cheaper than global equities, the discount has now risen to 50 percent, the largest gap since 1988, and has remained at this level for a couple of months. This is a gap twice the average of the past two decades.

Admittedly, Milan's blue-chip index has gained ground this year due to its strong component of banking stocks, which have benefited from the largest interest rate hike in eurozone history.

However, domestic companies, in sectors such as consumption and industry, have been hurt by an aging population, debt exceeding 100 percent of GDP and two decades of near-zero economic growth, interrupted only briefly by the post-Covid rebound.

This has meant that Italian stocks are overall priced cheaper even in comparison with weak U.K. stocks, which trade at a 33 percent discount to global equities.

The Italian stock market "is not an area where I would like to be particularly exposed," given concerns about Italy's fiscal outlook, said Chris Hiorns, head of multi-asset and European equities at EdenTree.

Recent cuts in economic growth and increases in budget deficit forecasts have rekindled fears about potential strains on government bonds, pushing the spread on Italian 10-year bond yields over 200 basis points last month against safer German Bunds.

Now the spread has narrowed, but remains vulnerable. A test looms on Friday, when Fitch will review Italy's BBB rating and stable outlook.

"A change in the outlook cannot be ruled out, given lower growth, higher interest expenses and Italy's deteriorating fiscal position," reads a Barclays note.

Goldman Sachs estimates that each 10 basis point increase in sovereign spreads takes about 2 percent off Italian bank stocks and 1.5 percent off the FTSE MIB index. The broker therefore advises avoiding the blue chip index after outperformance.

Italy's financing needs are further complicated by difficulties in meeting conditions set by the European Commission in exchange for the billions of euros in post-pandemic recovery funds.

Conflicts in Ukraine and the Middle East threaten to send energy prices soaring again and weaken growth.

The number of outstanding shares of BlackRock's iShares MSCI Italy ETF more than halved to 8.6 million from 18.9 million in October 2021. Over the same period, the MSCI Europe ETF saw the number of units decline by less than 10 percent.

"RIDICULOUS MULTIPLES"

Although Italy's weak economic outlook and high debt mean that significant stock appreciation is unlikely in the short term, investors expected some recovery given the steep discount enjoyed by some parts of the market.

The FTSE Italia Star index, which covers companies with a market capitalization of up to €1 billion, is down 10 percent so far in 2023, after the nearly 30 percent drop seen last year. In comparison, the FTSE mid-cap index is down 5 percent this year.

Smaller Italian stocks have been hit by selling related to the end of a government-sponsored scheme to promote investment in smaller domestic stocks, said Giuseppe Sersale, strategist and portfolio manager at Anthilia in Milan.

"Many companies are trading at ridiculous multiples. A window of value is opening on small caps, which is worth seizing," he said.

Andrea Scauri, senior portfolio manager at asset manager Lemanik, said high earnings visibility due to high rates and stronger balance sheets make Italian banks less vulnerable to debt strains than in the past.

"If the spread widens, this will have a short-term impact," he said.

Scauri owns shares in smaller Italian banks, such as Banco BPM and Monte dei Paschi, whose cheaper valuations make them more attractive than larger institutions.

Banco BPM's shares trade at about 0.55 times their price-to-book value and Monte dei Paschi's at 0.39 times, much cheaper than shares of UniCredit, Italy's second-largest credit institution by market value, trading at 0.66 times, according to LSEG Datastream data.

UniCredit's stock has risen nearly 80 percent this year and has stood out among the best-performing banking stocks in the euro zone.

Fidelity International portfolio manager Alberto Chiandetti said he is hunting for opportunities in the industrial and consumer sectors of the FTSE Italia Star index.

"In many cases, valuations have already taken into account the economic slowdown and do not reflect the value and growth that many of these companies will have in the coming years," he added.

(Translated by Enrico Sciacovelli, editing Stefano Bernabei)