A longer term perspective on the Italian referendum

When talking about political risks, Europe remains the epicentre in 2017. We have already seen the correlation between the Euro and Italian interst rate spreads rise to levels from the heights of the debt crisis, after a period where markets basically didn’t care about the periphery (low correlation), says Witold Bahrke from Nordea Asset Management.

Although December 4^th evening appeared initially relatively market friendly with the victory of the moderate candidate in the Austrian presidential election, the Italian’s clear rejection of Renzi’s reform proposals was a stark reminder of the elevated political uncertainty, markets are confronted with at the moment which most likely will be sustained for 2017 as a whole. A part from the fact that a NO was expected – although not such a clear result – and largely priced into markets, there are some positive aspects that might explain the benign short term market reaction. However, with GDP 7% lower than before the Great Financial Crisis, the key challenge is to get Italy growing again. For this to happen, a necessary condition is a strong government. Consequently, Italy’s structural woes and reform deficit are, if anything, increasing as a result of the referendum.

Italian politics have never been easy. Let’s try to understand: The current electoral law for the main chamber was meant to go hand in hand with the reform of the two-chamber system, which now has been rejected. It is giving a significant bonus to the winning party in the first round of the general elections. On current polls, this system would benefit the 5 stars movement, as 5 stars would be likely to contest against Renzi’s PD in the 2^nd round of an election. In that situations, the polls are giving the 5 stars a lead over PD, as most right wing voter would migrate to 5 stars in the 2^nd round. In other words, under the current electoral law, a 5 stars victory at the next election looks to be a serious risk from a market perspective.

However, the main mission of a care taker government will be to change the electoral system back to some kind of a majority system. In other words, since Renzi chose to step down, the likelihood of a near term reform of the electoral law for the main chamber (not the senate) has increased, which is positive from a stability perspective. It would mean a reduced probability of the 5 stars movement winning the next election, cf. above. It would probably be easier to form a coalition against any populist party. So further down the road, from a risk perspective the result might have removed the negative tail of the outcome distribution. That said, this scenario is based on current polling and we all know by now how reliable polls are...

Also positive from a market perspective: The result increases the likelihood of further monetary easing from the ECB.

So far so good one might say. But on the negative side, the referendum result means that whatever government might take shape before the next general election, it is likely to be a weak government, not geared towards further bold reforms that without doubt are needed in Italy. The banking system urgently needs to be dealt with, and it is questionable whether a new government might be able (or willing) to break the sovereign-bank nexus. Also, the result comes at a very delicate time when Monte Paschi (and possibly Unicredit) are set to raise capital and non-performing loans stand at breath taking 17% of outstanding credit. At the end of the day, markets will have very limited appetite to buy any Italian Bank asset as long as the economy is not growing.

Keep in mind that the referendum result partly is a rejection of Renzi’s (at least relative to former governments) pro-reform agenda. Therefore, it is not positive for the long-term growth perspective of Italy in our view, as the referendum at least at the margin will decrease reform appetite also after the next election – whenever that will be. It reinforces a more critical tone towards Europe and Berlin in particular. After all, talking tough on Europe will still be viewed as winning strategy in Italy.

Renzi might go for a strong come back when there’s a general election (Feb. 2018 at the latest), after an intermediate period with some kind of a power and/or reform vacuum probably will increase his chance of winning the next election. Stepping back now may even strengthen his position when running for the next election.

Given the political development in many European countries, Merkel is more than ever the liberal strong hold in Europe and possibly even globally. Therefore, the German general election next year will be more closely watched than ever by markets.