Weekly commentary from Wells Fargo Investment Institute on international topics in the news.
Peter Donisanu, Global Research Analyst
Italian Referendum—What to Expect from a “No” Vote
- On December 4, voters in Italy will head to the polls to determine whether the country’s constitution should be amended.
- A “no” outcome in Sunday’s vote has immediate implications for Italian banks, and near- to intermediate-term implications for the European Central Bank (ECB) and Italian and Euro area politics.
What it may mean for investors
- We expect a short-term increase in financial-market volatility as a result of a vote against the referendum—but ultimately expect financial markets to weather a brief period of uncertainty.
On Sunday, December 4, voters in Italy will head to the polls to determine whether the country’s constitution should be amended. An outcome favoring “no” would reject the proposed constitutional amendment. As we wrote about last month1, Italian Prime Minister Mateo Renzi has indicated that he will resign his post if the referendum vote fails. In recent months, Renzi’s approval rating has fallen, given weak labor-market conditions in Italy and concerns about the recent influx of migrants into the country. Indeed, Sunday’s vote may end up being more of a referendum on Mateo Renzi and less on the constitutional amendment—potentially leading to a result commensurate with the declining favorability of the prime minister.
If it happens, the outcome of a “no” vote on Sunday would have three important implications: 1) a potential liquidity squeeze for Italian banks, 2) a change in the timing of the European Central Bank (ECB) asset purchase program, and 3) renewed financial market concerns about the Eurozone breaking up following a further rise of populism politics in Italy and the Euro area.
First, some of Italy’s largest banks are facing financial difficulty and have looked to the capital markets in an effort to shore up their balance sheets. One such troubled bank, Banca Monte dei Paschi di Siena, is hoping to raise capital by issuing approximately €4 billion (or $4.27 billion) in stock by year end. In case of a “no” vote, European financial markets (particularly those in Italy) could experience a period of heightened volatility, making it more difficult for banks like Monte dei Paschi to secure capital from financial markets. Such an outcome could force the bank into a government bailout, which would require politically unpalatable losses to bond holders.
Next, the ECB’s Governing Council meeting on Thursday, December 8, comes just four days after Italy’s referendum vote, and market participants likely will be watching whether the central bank adjusts its asset purchase program. The Governing Council has indicated that, “…the monthly asset purchases of €80 billion (or $85 billion) are intended to run until the end of March 2017, or beyond, if necessary, and in any case until it sees a sustained adjustment in the path of inflation consistent with its inflation aim.” While financial markets experienced a Taper Tantrum in October on expectations that the ECB would conclude its asset purchase program in March 2017, a “no” vote on Sunday could leave the door open for the Governing Council to invoke the “beyond, if necessary” clause of its program—and potentially extend its purchase program if bond market conditions tighten.
Finally, next week’s referendum vote is likely to have broader implications for Italian (the Eurozone’s third largest economy) and Euro area politics into the coming year. Italy’s Five Star Movement (M5S)—an anti-euro political party—has garnered considerable popular support in recent years, winning the second highest amount of votes in the 2013 general election, while unseating establishment politicians in local elections this year. A “no” vote next week, effectively a referendum on Prime Minister Renzi, could provide the Five Star Movement with an opportunity to govern if parliamentary elections are called before 2018.
More broadly, populist movements appear to be gaining pace in other parts of Europe following those in the UK, U.S., and Italy. For example, general elections are due to be held in France and Germany in 2017, and the National Front (FN–France) and Alternative for Deutschland (AFD–Germany) could potentially add to the list of countries where populist movements have taken hold. Like the M5S, both FN and AFD parties possess some elements of Euroscepticism. In our opinion, a failed referendum vote in Italy could help build momentum for these other movements, setting off a year of uncertainty for market participants as to the political integrity of the Eurozone project and, more broadly, the European Union comes into question. That said, support for the euro project remains high among the electorate throughout the Eurozone, even in Greece where Eurosceptic party Syriza rose to governing power in 2015.
In our view, a “no” outcome in Italy’s referendum vote on Sunday is likely to give pause to the recent rally in global risk assets, particularly equities. This pause would come as market participants assess the potential impact to Italian and Eurozone banks, the trajectory of the ECB’s monetary policy, and potential political shifts across Europe over the coming year. Whatever the outcome of the vote next week, we believe that any market pause could be short-lived as financial markets fully digest the broad implications of the referendum vote.
First, even if Italian banks find it harder to obtain capital from capital markets following a “no” vote, we believe that policies crafted in the wake of the Eurozone’s recent financial crisis should mitigate systemic risks to Italian (Eurozone) banks.2 This should curtail longer-term concerns about systemic “contagion” risks among market participants. Next, we believe that persistently weak inflationary pressures make it more likely that the ECB will maintain its accommodative policy vs. tightening prematurely, as markets anticipated in October.
Finally, as for market participants’ concerns about political populism spreading across Europe, financial markets have already demonstrated resilience in the face of political uncertainty with Brexit and the U.S. presidential election. The Eurozone’s demise has been predicted numerous times since the height of the global financial crisis, yet the currency bloc in recent years has moved toward more integration.
Taken together, these three outcomes continue to support our favorable view toward capital markets, with a particular bias toward stocks over bonds. From an investment perspective, we remain neutral on Eurozone equities (as part of a broader regional allocation to European stocks). This outlook reflects a subdued economic growth environment across Europe. For international developed-market bonds, we remain underweight given ultra-low sovereign yields.
1 See our report, “International Briefing: Italy’s Upcoming Referendum Vote, November 10, 2016”, for a brief primer on the Italian Referendum.
2 See our report, “International Briefing: Eurozone Banks–It’s Political, July 15, 2016”, for a brief primer on recent policy changes for Eurozone banks.
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