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Europe's next big referendum

Jeffrey Sacks

By Jeffrey Sacks

Head - EMEA Investment Strategy

November 7, 2016Posted InInvestments

Economies around the Eurozone’s periphery have lost momentum relative to those of the core countries in 2016. That’s despite monetary and fiscal expansion across most countries. A lessening of pent-up demand and low savings rates is partly responsible here, along with a lack of economic reform, which has dampened confidence. The Eurozone as a whole still has high public and private debt ratios.

The most notable event within the periphery and Europe more broadly towards year-end is the Italian constitutional referendum on 4 December. Given the troubled Italian economic and banking-sector backdrop, and the potential ramifications should the vote go against Prime Minister Matteo’s reform agenda, there is heightened risk for Italy and some risk for the rest of the Eurozone

Italy’s economy has grown too slowly for several years and its present fundamentals look poor. Gross domestic product (GDP) growth is sluggish at an estimated 0.7% in 2016 and 0.5% in 2017. Its public debt stands at an all-time high of over 130% of GDP. Unemployment of 11.4% is still above its longer- term average of 9.4%.

The country’s banking sector, meanwhile, is struggling with €360 billion of non-performing loans (NPLs) on its balance sheet.  Italy has also been struggling with this year’s influx of refugees, with numbers estimated to have reached an unsustainable level of 157,000, according to UNICEF. The Italian government estimates exceptional spending due to the migrant crisis in 2017 will equal nearly 0.2% of Italian GDP.

The Italian electorate will be asked for its approval to amend the Italian constitution and reform the powers of the Italian parliament.  The key objectives of the constitutional reforms are:

1. Dissolving the two legislative chambers and changing the senate into an assembly, which will only vote on significant issues.

2. Provising a clear majority to the party winning the lower house's elections.

3. Removing the provinces from the constitution, which concludes the simplification process first started years ago.

4. reducing the number of senators from 315 to 100 and changing the process by which they are elected.

Those who favour the reforms believe that the current constitution is far too disjointed, and that having two separate chambers makes the decision-making process challenging, especially if the chambers are in opposition. The proposed reforms could also cut the costs of running the government, such as the reduction in the number of senators. However, those opposed to the reforms remain fearful that when combining the new reforms with the new electoral law, the Prime Minister would hold too much power, with democracy diminished. The opposition parties have all declared they are not in favour of the reforms.

The referendum has initially been viewed as a vote on PM Renzi and his government, as opposed to a poll on constitutional reform. Renzi’s popularity has noticeably declined over the last two years, dropping from above 50% to nearer 30% today. Earlier in the campaign, Renzi had stated he would resign if he lost the vote, encouraging the opposition to treat this as a way of removing him from office. However, he has since backtracked on those comments, trying to distance himself personally from the vote.

A “Yes” vote should see a positive market reaction, with the market valuation already reasonable at 11.6 times prospective earnings and with a prospective dividend yield of 5%. A “Yes” vote could improve investor confidence based on an Italian government more able to implement structural reform.  PM Renzi is expected to stay in power following such a result.  General elections have been scheduled to take place in early 2018 and a stable government following the referendum should be able to continue implementing reforms. The power of the Italian upper house will be diminished, and as a result substantial power will be recentralised in Rome and away from the regions.

A “No” vote may initially result in a brief indiscriminate sell-off in equities. The risk of subsequent events would rise, notably the heightened risk of PM Renzi resigning. The likelihood of a resignation would depend on the margin by which Renzi lost the vote, with a decisive loss potentially making his position untenable. Should he resign, there would be a heightened risk of further rating agency downgrades. Fitch already cut its outlook on Italy’s BBB+ rating outlook from stable down to negative in October.  We would expect substantial weakness in Italian sovereign bonds and credit in this scenario. While his resignation would not necessarily mean fresh elections were called, it would further open the door to the anti-establishment and Eurosceptic Five- Star Movement Party (M5S) gaining more popularity.