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Italy says no to reforms

Jeffrey Sacks

By Jeffrey Sacks

Head - EMEA Investment Strategy

December 5, 2016Posted InForeign Exchange, Investments and Fixed Income

- Italy referendum sees decisive vote against constitutional reform
- PM Renzi resigns, caretaker government likely
- Potential early elections in 2017 could open door to Euro-sceptics
- Bank sector recapitalizations now more challenging
- Remain underweight European equities and cautious on the Euro

Italy voted “No” to constitutional reforms by a margin of around 59.7% to 40.3%, on high turnout of about 70%. The constitutional referendum aimed at reducing the number of senators and the legislative powers of the Senate. Currently, the upper house carries as much weight as the lower house. It also sought to centralize power at the expense of Italy’s twenty regional governments. Although the referendum was about constitutional reform, it was treated as a vote on PM Renzi, who had tied his political future to the outcome. Given the margin of the “Yes” defeat, it is unsurprising that he resigned as PM, while he is also under pressure to resign his leadership of the Democratic Party.

The country now has 77 days in which to form a caretaker administration. While Italy has a long history of government changes within the same parliament, there is a possibility a caretaker administration cannot be formed, in which case the February 2018 general election is likely to be brought forward to early 2017. A complication is that an electoral law change to give the lower house proportional representation would need to be put in place before the election.

One of the risks of an early general election, would be the possible rise in popularity of the Five Star Movement, which campaigned for “No” in the referendum. The populist party has a growing support base and wants to hold a referendum on quitting the Eurozone. The increasing resonance of its anti-establishment, anti-elite message has similarities with the Brexit and Trump campaigns. This matters strongly in Europe, where there are general elections next year in the Netherlands, France, and Germany. It is notable that in the Austrian presidential election held yesterday – which was won by the centre-left candidate – the far-right-wing candidate Norbert Hofer still managed to win 48.3% of the vote.

The Italian referendum result might also raise risks for the banking sector. The €360 billion of sector non-performing loans – figure 1 – as well as one of the largest government debt loads in Europe – equal to around 133% of GDP – have been a burden for several years already. The sluggish economy – now 12% smaller in output than before the Lehman crisis – further exacerbates these problems. The banking sector is now critically dependent on recapitalizations, of which PM Renzi had been supportive, starting this month with capital raisings for Italy’s third largest bank, Monte del Paschi, as well as Unicredit. These capital raisings are likely to be an important barometer of investors’ medium-term sentiment towards Italy, and could be hampered if any of the rating agencies downgrade Italy on the back of the referendum result. (Fitch and DBRS both have Italy under review).


As figure 2 shows, the Italian market has underperformed so far this year. Within the market, the banking sector has been particularly weak, down 50%. This partly explains why the market has been resilient today in only falling by 1.41% by early afternoon. The bond market has also been reasonably resilient. The 10-year Government BTP yield is only 12.6 basis points higher at 2.02%, double where the yield was four months ago yet well off the 7% level of early 2012. Similarly, Italian corporate bonds have been slightly weaker overall, with particular weakness in bank issues.

The Euro opened weaker in illiquid Asian markets however is now flat on the day. The short-term direction is likely to be driven by the European Central Bank (ECB) meeting this Thursday. Before the referendum, the Citi and consensus view had been that the ECB might announce the start of tapering from March 2017 onwards, from €80 billion bond purchases per month to €60 billion, along with a six-month extension of the asset purchase programme, as well as technical  adjustments to increase the size of the eligible bond  universe. Now it is possible that the ECB might delay tapering, which would likely keep downward pressure on the Euro.

After Trump’s victory in early November, the Global Investment Committee reduced the European equity weighting, and within that the Italian equity weighting, from neutral to underweight. The main rationale for that – rising political risk in Europe more than offsetting reasonable valuations – remains firmly in place. We should recall that the immediate Brexit and Trump market impacts did not fully discount the full medium-term economic impacts upon the UK and US respectively, and we should similarly expect the situation in Italy to evolve over the coming weeks.