Italy’s constitutional referendum on 4 December is unlikely to deliver the type of shock caused by the UK’s Brexit vote or Donald Trump’s electoral triumph in the US.
But this shouldn’t provide investors with much comfort. Increased political uncertainty could exacerbate problems for the country’s beleaguered banks. And regardless of the referendum outcome, Italy faces a challenging outlook— economically and politically.
The referendum itself is about downgrading the role of the Senate (Italy’s upper house). Together with earlier changes to the electoral law governing the Chamber of Deputies (lower house), the referendum’s supporters hope the new system will at long last provide Italy with strong, stable governments. The country has had 64 different governments since World War II.
In our view, the best near-term outcome for markets would be a yes vote: Renzi would remain prime minister and political anxieties would ease, at least for the time being. A no vote, by contrast, would lead to a period of heightened political uncertainty.
By far the worst outcome for market stability would be a no vote that triggers snap elections. That’s because Italy’s new electoral law could, in theory, allow the maverick Five-Star Movement (M5S), which opposes Italy’s membership of the euro area, to gain control of the Chamber of Deputies.
The good news for markets is that snap elections are unlikely. Even in the event of a big no vote, Italy’s president is likely to appoint a transitional government. And one of its main tasks would be to water down the electoral law ahead of fresh elections (the next parliamentary election is due by May 2018).
A dilution of the electoral law is also likely in the case of a yes vote. That’s partly because of the threat posed by M5S and partly because the law may not be legal (the Constitutional Court is due to rule on this early in the new year). But while this would make it more difficult for M5S to gain power, it would also make it more difficult for Italy to elect a strong government, the original aim of the reforms.
Longer term the referendum has the potential to inject significant short-term volatility into European credit markets, and Italy’s beleaguered banking system makes it particularly vulnerable.
With government debt at 133% of GDP and rising, Italy remains heavily dependent on the benevolence of the European Central Bank (ECB) and its President Mario Draghi. We expect ECB support to continue for some time to come. Italy remains one of the euro area’s key fault lines. Whatever happens on December 4, investors need to pay close attention to the potential fallout.
Darren Williams is European economist at investment management firm AB