Anti-establishment sentiment has shaken markets this year, delivering a ‘Brexit’ vote in the UK and a surprise win for Donald Trump in the US elections. Are markets prepared for the next episode, if Italy votes against constitutional reforms in December?
Italy’s political system is notorious for its instability, which makes it very difficult for meaningful reform to be implemented. With equal powers for the upper and lower houses, coalitions continuously struggle to achieve outright majorities, leading to political paralysis and frequent government reshuffles.
Prime minister Matteo Renzi and his Democratic Party have made considerable efforts over the past two years to push through structural reforms to streamline Italy’s political and economic framework. The appropriately labelled ‘mother of all reforms’ is the constitutional reform, which can be split into two separate processes:
1. The electoral reform (or ‘Italicum’): Passed in 2015, this aims to reduce instability in the lower chamber of the Italian parliament. Under the new electoral law, the single party that receives the most votes controls the lower chamber with 55% of the seats.
2. The Senate reform: This intends to bring an end to perfect bicameralism, by meaningfully weakening the power of the Senate. The constitutional reform would therefore shift the centre of political gravity towards the lower chamber, boosting the majority party’s power to pass laws and reforms
In 2015, Renzi announced that the constitutional reform had to be approved by the Italian electorate directly via a referendum, now scheduled for December 4th 2016. Importantly, Renzi initially aligned the referendum to his premiership, committing to resign should it not pass. This turned the referendum into a vote of confidence on the current government and a highly ‘politicised’ vote on Renzi’s rule, rather than on the proposed radical constitutional reforms – which Italy needs in order to streamline legislation and steer growth.
With the ‘no vote’ currently in the lead and gaining in strength, a negative outcome in the referendum has largely been priced in. Recent investor surveys show that a ‘no vote’ is expected to have a largely neutral impact on Italian equities (Chart 1). Similarly, Italian BTPs now are priced at a level consistent with a negative outcome on December 4th.
Chart 1: The referendum is influencing asset allocation and risk taking in European assets
Source: Fidelity International, Autonomous Research, 10 November 2016. Survey question “Is the Italian referendum having an impact on your current risk appetite / investment strategy when ~it comes to investing in European assets?”
But a ‘no vote’ would be yet another act of protest against the status quo and established politicians, bolstering the populist trends that are taking hold globally. Markets would closely follow Renzi’s reaction and the implications for the Italian government.
The markets’ base case in this scenario is that there would be a government reshuffle under Renzi as prime minister or a new coalition government formed with current coalition partners. While the market impact of this scenario would probably be limited, the new government would shift its focus onto reversing the ‘Italicum’ electoral law, effectively bringing the reforms agenda to a standstill.
In a more extreme scenario, should Renzi follow through with his initial promise and resign without a government reshuffle, fresh elections could be on the cards. The M5S would receive yet another boost and stand a strong chance of taking power. Markets would not take the anti-establishment shift lightly, and would demand a higher risk premium to hold Italian assets.
A referendum victory for Renzi would be the best result for investors, at least in the short term, as the discount on asset prices for the risk of a negative outcome is removed. It is unlikely that Renzi would call for early elections as the M5S would still retain strong support among the electorate, and could outdo the PD if new elections took place under the current electoral law. It’s a risk that Renzi would be unwilling to take.
As was the case this summer, heightened political tensions will increase the pressure on the Italian banking system, at a time when both Montepaschi and UniCredit are planning to raise capital. A no vote in the referendum could upset the Montepaschi recapitalisation, in a worst case scenario even leading to nationalisation of the bank. Ripple effects would be felt across the entire sector and might make it more difficult for UniCredit to complete its own capital raising in 2017.
Despite the uncertainty ahead, Italian fixed income assets offer value at current levels. BTPs already discount a negative outcome, and will benefit from further ECB support. Financial corporate bonds issued by national champions stand to benefit from ongoing recapitalisation efforts and capital raising exercises, at the expense of equity holders, while the ECB’s corporate bond buying programme will keep yields of non-financial corporate bonds in check. In equities, while a negative referendum outcome could create short-term volatility and weigh on Italian banking stocks, the impact beyond financials is likely to be more muted.
Alberto Chiandetti (pictured left) is portfolio manager, European equities, and Andrea Iannelli (pictured right) is investment director, Fixed Income at Fidelity International