Italy opts for the status quo - J.P. Morgan Asset Management
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Italy opts for the status quo

Contributors Maria Paola Toschi, Global Markets Insights Strategy Team
In brief
  • With a high level of turnout (68%) and a huge gap in favour of the NO supporters (60% against 40%) Italy has rejected Constitutional reform. As a result the Prime Minister Matto Renzi announced the intention to resign opening a period of political uncertainty.
  • The No vote did not come as a surprise and was already broadly priced into markets.
  • However, we may still see volatility given the uncertainty over what happens next - and over the broader political implications of the result.
  • Beyond the immediate market reaction, there may be broader consequences for Italy’s financial system, and for the country’s banks in particular.
  • The result also represents another sign of the anti-establishment sentiment that has dominated the political landscape this year - a concern given the busy European election calendar in 2017.
Back to political impasse

Structural issues in Italy have contributed to a prolonged period of low growth and declining competitiveness in recent decades. The prime minister, Matteo Renzi, and his government have pursued a very ambitious programme of reform aimed at addressing some of these issues - of which the Senate reform that has been voted down in the referendum was a crucial part. The referendum was therefore seen as a political test for the government - and the No victory was considered a vote of no confidence, that put at risk the survival of the current coalition.

It is still early to make predictions about the consequences of the dismissal of the PM Renzi. The experience of this reformist government is over showing the high resistance of people to changes and the suspicion versus the political establishment.

However, it seems still difficult, that the country could call a snap election, given that political parties will now need to re-examine the electoral law as an indirect effect of the rejection of Senate reform. The most likely outcome is therefore that the President of the Italian Republic will give a mandate to a candidate to form a new government, a very lengthy and complex process with a prolonged period of uncertainty, with negative implications for the Italian economy.

Expected result - but uncertainty lies ahead

Markets were pricing in the No result, with the Italian government bond spread over the German Bund widening in the run up to the referendum (Exhibit 1). However, we can still expect volatility in the near term given the uncertainty over Italy’s political future. In the long term, the implications for European bond markets will depend on the entity and duration of the political crisis, although the European Central Bank’s (ECB’s) bond purchase programme could potentially reduce the risk of extreme volatility.

In the weeks before the referendum, the spread between 10-year Italian and German sovereign bond yields widened, meaning markets were already pricing in the No result.
Exhibit 1 – Italian and Spanish 10-year sovereign bond yields vs. 10-year Bund

Source: Bloomberg. J.P.Morgan Asset Management; data as of 30 November 2016.

Bond market turbulence could have serious implications for the financial system. Most importantly, the Italian government would have to finance its huge debt burden at increased borrowing costs as a result of the effects of uncertainty on bond markets.

In addition, Italian bank balance sheets may suffer, given the overexposure of the country’s lenders to domestic sovereign bonds. The government collapse and the prolonged period of political uncertainty will also slow down or halt the rescue and recapitalisation processes that are underway, as well as the bad bank programme, while foreign investors may be less willing to underwrite capital raisings of Italian lenders.

It should be noted that valuations of Italian and European banks are at very depressed levels, meaning they are already pricing in the huge difficulties involved in the rescue programme (Exhibit 2). But the effect of the referendum result on European confidence could fuel a prolonged period of disaffection in a sector that was showing signs of moderate improvement.

European banks are already trading at depressed valuations, meaning many of the issues they face are already priced in.
Exhibit 2 – Price-to-book value ratio of European banks

Source: Bloomberg, J.P.Morgan Asset Management; data as of 15 November 2016.

Growing anti-establishment sentiment

The Italian referendum ends a year of headline political events, including Brexit and the US presidential election. The results of all these popular ballots seem to have the same root: an increasing sense of mistrust and dissatisfaction with establishment parties as a result of the global financial crisis.

In 2017, the European Union will still have to deal with the unpredictable implications of Brexit. The No victory may add to the sense of political chaos and fuel the rise of populist parties not only in Italy, but also in Europe on the threshold of important general elections next year in Austria, France, the Netherlands and Germany.

Investment implications
  • The Italian constitutional referendum was a key political event not only for Italy but for Europe as a whole. The No victory represents the less market-friendly outcome.
  • The PM Renzi announced the intention to resign opening a new period of political impasse in Italy, with negative effects on an economy that was showing signs of moderate recovery.
  • The rejection of Senate reform adds to worries about anti-establishment sentiment ahead of important elections in 2017. The referendum result could put the Italian and European banking sectors under more pressure, creating risks to financial stability and increasing the need for European equity investors to take a highly selective approach.
  • We could see some volatility in Italian government bonds in the short term, but it will be difficult for spreads to revisit the extreme levels seen during the 2011 and 2012 debt crisis thanks to the support of the ECB. Italy is the third-largest target market for the ECB’s bond purchasing programme, potentially deterring speculative attacks on the country.

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