The article is prepared by Giancarlo Prisco, trading strategist and analyst for Admiral Markets for the Spanish and Italian markets. He has been Financial Advisor for Finanza&Futuro (Deutsche Bank Group).
Licensed in Economy and Financial Institutions by Bergamo University (Italy), based his thesis in the Technical Analysis field.
Since 2008 he has worked as an independent technical analyst for the main financial markets. He collaborates with different Italian universities and a variety of media as a market analyst.
A constitutional referendum is coming. What effects and consequences can we expect to see in the markets and the Italian economy in either outcome of a constitutional reform by Renzi?
The Italy referendum 2016 will take place on 4 December and will decide the fate of the Renzi-Boschi reform, part of the constitutional law passed by Parliament on 12 April. The law passed with fewer than two-thirds approval by the members of each chamber, so is therefore subject to the outcome of a popular consultation — only the third in the history of the Italian Republic, following those of 2001 and 2006. Since it's not a repeal referendum, it will not have to reach any quorum to be considered valid. The reform will be approved if the number of votes 'for' is greater than the number of votes 'against', regardless of the turnout.
The constitutional referendum could represent the most grave danger for financial markets, with analysts potentially overestimating the negative effects of a hypothetical victory for 'NO'. Defeat for Matteo Renzi on 4 December will not be a "healthy" result for the markets, creating the potential for a "bloodbath", primarily for BTP and FTSE MIB. In recent weeks, volatility in the domestic market is considerably high and the correction on the stock market (banks in particular) has been important. Even BTP has lost ground, like all the bond markets with a "leverage". It's easy to look back and analyse the events of the past, but what really worries investors is the future. This referendum may have a big impact on the upcoming general elections in France and Germany in 2017.
Constitutional referendum: the political effect of NO or YES
The potential effects of Premier Renzi's defeat in the constitutional referendum on 4 December are wide-ranging.
If the majority of Italians vote 'NO', reform to the Constitution will not be approved and none of the changes expected by the Boschi Law will come to pass. This means:
1) No cancellation of CNEL;
2) No reduction in the number of senators;
3) Parliament will still be characterised by equal bicameralism;
4) The text of Title V will be approved by the 2001 reform;
5) Senators will be elected and not appointed;
6) Provinces will not be eliminated.
If the 'NO' vote wins, it is very likely that the Prime Minister currently in office will be ordered to resign by the President Mattarella.
Having taken this into account, there are three main scenarios:
1) The President of the Republic does not accept the resignation and invites Renzi to remain in place. The expiration date of the legislature is 2018.
2) The President of the Republic accepts the resignation and gives back the mandate to form a new government to the actual Prime Minister, confirming the natural end of the legislature until 2018.
3) The President of the Republic accepts the resignation and, after consultation, noting the inability to find a parliamentary majority in support of a so-called "Renzi-Bis", gives an authoritative political figure the task of forming a caretaker government which will last until the date of the new parliamentary elections in the spring of 2017.
Hypotheses one and two would not be too harmful to the BTP curve, the actions of the banks and the FTSE MIB, or European indexes in general. There may be high volatility, but only in the weeks immediately following 4 December. The most damaging scenario for the markets is hypothesis three, which would see early elections in the spring of 2017 and Five Star Movement (M5S) become the first party in Italy. But it is unlikely that such a plebiscite vote would allow a one-party government.
So, without the 5 Star Movement, it receives an absolute majority in the Chamber of Deputies (and even the Senate). With the electoral system being the so-called "Italicum", a newly-elected parliament would be made ungovernable (M5S would hardly make agreements with other parties) and could even open up the possibility of a second early election in the fall of 2017.
A 'YES' victory in the referendum would certainly make the Italian market more attractive in the eyes of foreign investors, because the victory would lead to Renzi postponing early elections and allowing some breathing-space to the government in power until the 2018 elections.
Constitutional referendum: the next market storm?
If at first it may feel a bit of a stretch to compare the Italian referendum to Brexit and the US elections (at least in a political sense), the economic consequences are certainly comparable. Italy remains, for the size of its public debt and its current geopolitical role at this moment (fronting the cost of the reception of migrants, recent earthquakes and the related controversy over coverage of these costs), a special case. Its financial importance goes beyond the political aspect and will be able to define the market performance not only in Italy but throughout Europe.
The media outside Italy has coined the term " Italexit", even though the Italian referendum does not have the same political implications as Brexit. Therefore, Italy's EU membership is not currently at risk.
Still, the referendum seems to paraphrase the Brexit: if not in a political sense, then certainly in terms of its connotations. It's a systemic risk for the European Union, which saw one of its major founding members severing ties with it. The domestic economic difficulties, despite even the massive help by the European Central Bank, endanger the stability of the entire European economy. Taking into account recent political trends (the spread of populist movements) and the 2017 elections in France and Germany, all these issues can be dangerous.
In addition to the reasons expressed, the result of the referendum could affect the outcome of bank recapitalisations provided closer to the event, in particular the Monte dei Paschi di Siena bank.
The impact on the continental institutions (Deutsche Bank in particular) could be immediate. In the current context of generally rising yields on government bonds, further accelerated after Trump, it is not certain that the ECB can maintain the situation. The BTP-Bund spread could deteriorate, creating another difficult problem for the EU to deal with. The risk of a 'NO' vote victory would potentially present the conditions for a euro implosion.
Even though we do not underestimate the gravity of this, it still seems a remote possibility, because the current economic situation of our country is very different when compared to the Greek crisis in 2012. Then, the ten-year BTP was almost 7%, compared to 2% today. At the same time, our budget deficit is at 5% of GDP, compared to 2.4% today, which is well below the level of France and Spain.
View of foreign investors: consequences for the Italian economy
The initial statement — "if I lose, I go" — made by Prime Minister Renzi, meant that foreign investors see the referendum only as a confirmation of the reforms carried out by the Renzi government. A vision that is perhaps simplistic, but causes a great deal of nervousness in anticipation of the result.
However, we must not forget the recent precedent of voting, i.e. Brexit, with which the Italian referendum shares a similar birthdate (December 2015 for Brexit and March-April 2016 for the Italian referendum), as well as the ultimate aim of the leadership that promoted these events to strengthen the opposition parties.
In practice, foreign investors see a victory for the 'NO' vote as "the beginning of the end" for the reforms initiated by Renzi, predicting a bleak future dominated by political uncertainty and the prevalence of populist movements (M5S) which could even lead to a referendum on membership of the euro.
This post-election political uncertainty obviously implies the absence of concrete initiatives to promote economic growth and employment. This prompted a number of international banks to assume a downward revision of Italian economic growth of around -0.3% to 0.5% of revised growth in 2017 and from 0.9% to 0.6% in 2018. The cause is primarily the slump in investments by Italian companies in Italy and renunciation of foreign companies to make new investments in Italy, which would have serious implications for employment and the level of domestic consumption. In the absence of a sustained growth in loans, the issue of NPLs (non-performing loans) of banks and their low profitability would become a chronic problem, with no easy short-term solution in sight.
Another point is the public finances. At the end of 2015, according to official data of the MEF, the Italian public debt amounted to 2.2 trillion Euros. A share equal to 85% was made up of government bonds in circulation, 1.87 trillion euro. Of these 1.87 trillion, 40% were held by foreign investors and 60% by domestic investors (Bank of Italy, banks and insurance companies, funds, companies, families).
Foreigners own 40%, including derivative instruments (BTP future), which is sufficient to trigger a sell-off of Italian government bonds. This is a prevailing scenario among financial analysts who expect the victory of a 'NO' vote and Renzi's resignation. Sales would come mainly from abroad. Italian banks and insurance companies would experience difficulty in supporting prices of BTP.
If the ECB does not come in defence of the BTP, it is likely that the sell-off will also hit banking and insurance bonds, senior and subordinate, showing an evident link between banks and insurance as well as BTP in the financial statements. With quantitative estimates of this rise in analysts forecasts (rates are very different from each other) we can suggest an increase in the long-term section of the Italian curve of about 100 bps or more, and the curve of the subordinated banks and insurance of 150 bps (to explain, 10y BTP would make between 2.50% and 2.70% from the current 2%). Also, they do not exclude similar shocks for the "peripheral bonds" of Spain and Portugal.
There are medium to long-term consequences of the post-election political instability in 2017. Consider the potential for a victory for M5S in the early elections in 2017, given that they are open to parliamentary alliances, it could lead to the formation of a majority capable of governing. Here, the scenario leads to the implementation of a "populist" program with expansion to public spending.
One of M5S' flagship policies is the so-called "citizen's income" (a subsidy of 600 euros for the unemployed and the poor, with the burden placed on state coffers amounting to about 20-25 billion euros). At the same time, it means a commitment to reducing taxes. This would deteriorate the deficit/GDP ratio (from -2.6% in 2016 to -3% in 2018) and the absolute growth trend of public debt (135% in 2016 to 137%-138% in 2018).
This perspective introduces another important consequence for the curve of Italian rates in the medium-term perspective: the worsening of the financial statements as a result of political instability would mean a downgrade from the rating agencies in the following months. The most dangerous is the one by S&P because it would lead us to BBB- from BB+. In other words, to "junk" level (i.e. sub-investment grade), with all negative consequences for the Italian financial sector.
Despite the Italian referendum appearing as a purely domestic issue, the media and analysts around the world have been eager to uncover what Italians think about "Italexit".
Surveys on the Italian referendum odds currently see the 'NO' ahead of 'YES', with a percentage ranging from 4 to 8 points, according to polling agencies (according to Sole 24 Ore, it's 34% vs. 29%). There remains a very high percentage of undecided voters, or those likely to abstain, which is hovering around the 35%/40% mark.
With the high degree of uncertainty in the polls, t he possibility that the vote expresses a different result from the survey is statistically significant. We remember the results of surveys on voting in the United Kingdom in the days immediately preceding polling day and those related to the US presidential election before 8 November. The UK saw the 'stay' vote leading over 'Brexit' — 52% to 48%. While in the US, surveys estimated Hillary Clinton's lead over Donald Trump as between 3.3 and 4.6 percentage points. We all know how it ended in both cases. So the benefit of the doubt must be afforded a voice. Also, it probably shows a reluctance of some of the respondents to reveal their true opinions.
The impact of a 'YES' or 'NO' win on the market
If 'NO' wins
The previous cases of Belgium and Spain experiencing long periods without having a new government (530 days in the first case) following elections, and thus the circumstance of political crisis, does not represent a dramatic situation for the stock markets.
If the current government could prove stable enough to handle even a few program points, the basic trend of the market will not be significantly altered. The ECB's presence should allow the BTP / Bund spread to not expand over the 210 basis points reached in recent days. In the Italian situation, the burden of the recapitalisation of the banking system definitely weighs more in terms of the requests on the European regulator, due to the higher degree of suffering and a doubtful will to grant loans.
The eventual dominance of a 'NO' vote would complicate the already problematic recapitalisation of MPS and Unicredit banks, with a contagion effect on other lenders and the structural weaknesses of the Italian banking sector (with few exceptions). It depends on how the markets will address the event. From the beginning of November, FTSE MIB has been at -5%, and the Italian bank index at -4.5%.
European indices have stayed in a strict range since 10 November. There are too many problems that hinder the uptrend. On one hand, there is the Italian referendum; on the other, the cohesion of Member States seems to waver and forces major European markets to maintain caution. The banking sector adds another climate of hostility between Germany, Italy and the ECB. The dollar continues its ascent, so we can easily imagine EUR/USD equality in the coming weeks.
If 'YES' wins
If 'YES' prevails, the current unbalanced market positioning would leave space for a bullish trend. It would see the upside of the sectors that have suffered more, such as banking / finance. It's more probable that we are going to see a shrinking country risk on the market and investors either buying significant shares of the banks in the process of making capital increases or the assets put up on sale by the same banks.
The narrowing of the spread BTP / Bund would also help the so-called "interest-sensitive stocks", although it is difficult to expect a return to the "rates at zero forever" scenario, which dominated until recently. The euro could strengthen in the immediate post-voting period (before the Fed raises interest rates in mid-December), promoting the recovery of raw materials that benefitted from the strength of the dollar.
Investment conclusion: many negative factors are already well-known and discounted
The market is already becoming weaker, just one week before the referendum. Both the annual performance (with the FTSE MIB losing a little less than a quarter of its value from January 2016) and the performance at the beginning of the month (4%) give a good overview of the critical aspects of the referendum.
At the same time, the dollar has appreciated, beating all forecasts. Before the US elections, many analysts were convinced that when Trump became president we would have experienced a collapse of the indices and excessive appreciation of the euro. In truth, the exact opposite happened.
The US economy is growing strongly and the next macroeconomic data, assuming it beats the forecasts, will lead the indices to new heights. Consequently, appreciation of the dollar will lead to an almost equal USD/EUR exchange rate.
Our conclusion is that the best part of uncertainty is already discounted in prices, even in cases where polls were telling the truth about the outcome of the referendum. Uncertainty is the keyword that has dominated in recent weeks and now it will finally decline. That's why we think that even if we see the victory of a 'NO' vote, the bearish emotional reaction of the markets will be short lived. Similarly, an unexpected 'YES' victory would reduce the immediate risk the country experiences in terms of its domestic financial assets, but it will not solve the problems of the Italian economy in general and banks in particular.
In 2017, we will see more effects of the Italian referendum, but for now the markets are focused on FED and Yellen on 14 December. The last decision of the actual president could put a great amount of short-term pressure on the markets (raising the interest rate the week after the Italian referendum), though the actual trend of American indices are bullish. We can expect a change of actual bullish trend in dollar and a EUR/USD, stabilising at 1.06/1.08. Gold is going down and it's yet another signal that the bullish trend needs more stimuli to change the actual situation. With the help of Mario Draghi, we may maintain the good index trend for one more year. As always, the markets will have the last word.