What next for Europe and the UK as an Italian referendum looms

David Zahn is head of European Fixed Income at Franklin Templeton Fixed Income Group.

With the swifter-than-expected appointment of a new UK prime minister, investors might be hoping that the post-referendum uncertainty in the United Kingdom should be dying down.

David Zahn thinks there should be cause for some optimism, notwithstanding the numerous challenges ahead. And, he has news for anyone who thought they’d heard the last of referendums in Europe this year.

The swift appointment of a new UK prime minster, just weeks after David Cameron’s post-referendum resignation, should be a positive sign for the United Kingdom.

Markets don’t like uncertainty and the fact that Theresa May seems to have entered 10 Downing Street with a clear sense of direction should offer a strong message to markets.

One of her clearest signals is her indication that there would be no backing down from the United Kingdom’s withdrawal from Europe, and her insistence that it’s her job to get the best deal for the country.

We think that should help UK market sentiment. There remains some uncertainty about how negotiations will proceed, and we think there will have to be some give and take. But we believe some sort of deal will be struck because Europe needs the United Kingdom and the United Kingdom needs Europe.

There has been a lot of talk of the United Kingdom adopting the Canadian, Norwegian or Swiss model for its relationship with the European Union (EU); we think the United Kingdom will do its own thing and go for its own model—likely to be a hybrid of several approaches.

An important matter some people may have overlooked in considering why Europe needs the United Kingdom is defence. Not having the United Kingdom in the EU would likely weaken the EU’s military capability.

The United Kingdom is one of the few countries in Europe that spends 2% of its budget on defence. Most other countries are well below that. So it’s possible that some kind of co-ordination in regards to defence could form an important component of negotiations.

While much of the attention in the coming months is likely to be on the politicians, monetary policy is also likely to be an important pillar. We think government stability, a weaker currency and accommodative central bank should help minimise the economic repercussions of Brexit.

So far, Bank of England (BOE) Governor Mark Carney appears to be very supportive of the markets. We’ve seen in a number of regions across the world where politicians are not as focused as they could be on the economy, and central banks have tended to step in.

We would likely expect an economic slowdown in the United Kingdom, and the BOE is likely to have a plan to respond. However, we don’t think the BOE’s Monetary Policy Committee would want to cut rates too much further. Negative rates would not be as effective in the United Kingdom as in other regions, in our view, because so many people in the United Kingdom have mortgages tied to the BOE base rate.

Is Italy going to the polls too?

Meanwhile, as the rest of the Europe reflects on the aftermath of the UK’s Brexit vote, another potentially disruptive referendum looms on the horizon: this time not on EU membership, but on the Italian constitution.

After failing to get planned constitutional reforms through both houses of the Italian parliament with the required majority, Italy’s Prime Minister Matteo Renzi is expected to put his proposals to the country’s voters in a referendum.

There’s no scheduled date for the vote yet, but it’s expected to take place during October/November.

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