Italy will be all right on the night

This Sunday, we have the last big political risk event of the year with the referendum in Italy and the results are hard to predict.

referendum in italyTwo things have been a consistent theme throughout 2016: Fed hikes and political surprises; the US elections and the UK referendum on Brexit being prime examples. It’s therefore fitting that as the year approaches its end, one Fed meeting and one referendum remain. The Fed meets on 14 December, but before that, this Sunday, we have the last big political risk event of the year with the referendum in Italy.

So, what’s it all about? As is often the case with referendums, there’s “what’s it about” from a legal sense and then “what’s it about” from a more power-political sense. We’re going to concentrate on the former and its implications for debt markets. The latter, we shall leave for the political pundits.

On 4 December, the Italian electorate will be asked (in one question) if they wish to accept several amendments to the Constitution. The most important feature of the amendments is the reduced role of the Senate. Currently, the Senate and the Chamber of Deputies hold equal power, which makes passing legislation challenging. A No vote would mean maintaining the status quo and a Yes vote would mean that legislation can be passed more easily in the future.

This time it’s personal
The referendum holds significant importance as the prime minister, Mr Renzi, has made it personal by promising to step down should the electorate reject the referendum. While the promises of politicians should always be taken with a heavy dose of salts, Mr Renzi’s possible departure could set off a political crisis. Doubts about the state of the Italian financial sector are rife and the last thing investors want is an injection of political instability. In our view, however, the current fears are somewhat overdone.

Likely effect on markets
The results of the referendum are hard to predict. In the last poll published prior to the two week poll blackout, the No camp held a solid lead, but the undecided camp is large, with up to 25% of voters not knowing which way they will lean. It’s also worth keeping in mind that election polls throughout this year proved to be as reliable as a 1970s Alfa Romeo: they looked solid, made all the right noises and were great entertainment value, but once you shifted it into first, the gearbox fell out.

Bearing in mind this uncertainty, here is our view of the possible market reactions to the referendum result:

Yes Vote. Expect strong outperformance of Italian assets. In our view, fixed-income markets have largely priced in a No vote and a Yes vote would be a strong surprise. However, let’s not get carried away – how exactly Mr Renzi will actually use his increased mandate to implement new reforms is yet to be seen. Just yesterday, there was an unconfirmed news report that Mr Renzi could offer his resignation even in the case of a Yes vote. He would then seek re-appointment in the hopes of forming a new government with a broader majority.

No Vote. Negative performance of Italian assets should be limited. We still see this as the most likely result. In a tight vote, expect Mr Renzi to step down, but be asked back to head a new government by President Mattarella. In case of a strong No vote, the loss of credibility to Mr Renzi will be too much. In this case Mr Mattarella will have two options:

Implement a new technocratic government.

A new government headed by the possible candidates Pier Carlo Padoan or Carlo Calenda.

Both of these options could mean more political instability and slow the healing process of the Italian banking sector as outside investors might shy away. We do not foresee a snap election that could bring the Eurosceptic 5-star movement to power as such an election would need to be called by the president who seems disinclined to do so. However, any possible sell-off should be confined. The European Central Bank (ECB) meets the Thursday (8 December) after the referendum and any strong negative market move in Italian government bonds and periphery in general will likely be met by countermeasures from the ECB.

How are we positioned?
As we have stated throughout the year, we believe the market is too negative on Italy and the worries are exaggerated. We are overweight Italian bonds and in particular we like the Italian banking sector. We have exposure to well-run Italian banks such as Intesa and Unicredit and consider the recent underperformance as unjustified and thus an opportune entry opportunity. In a No vote a sell-off should be limited and could prove short-lived as in the upcoming ECB meeting countermeasures are likely to be announced. So indeed, a fitting year-end ahead of us full of politics and central-bank action.

Comment by Daniel Karnauss, Vontobel Group