No sooner have global markets digested the Brexit decision and the election of Donald Trump as US President (arguably “Brexit Mark 2”), another risk event now looms on the horizon: Italy’s constitutional referendum on December 4. As this note explores, should voters reject the referendum (as polls indicate they might), it could lead to further weakness in the Euro and an extension of accommodative central bank policy – both of which could, perhaps perversely, aid European equities, at least on a currency-hedged basis. European concerns could also add to the Trump-related upward pressure on the US dollar.
Italy’s Referendum: The Growing Risk of a “No” Vote
In a bid to make the passage of (often tough) economic reforms easier through the Italian Parliament, Prime Minister Matteo Renzi has proposed constitutional changes to effectively reduce the “blocking” power of the upper house Senate. The referendum is scheduled to take place on Sunday December 4, and Renzi has threatened to resign if the constitutional amendment is not passed.
At this stage, however, the polling suggests the “no” vote is in the lead, not helped by the fact that major opposition parties, such as Berlusconi’s Forza Italia, the populist 5 Star Movement (run by a well known comedian!), and the right-wing Northern League party, don’t support the change. The actual measures proposed are quite complex, and in light of the anti-elite backlash that has been recently evident in the United Kingdom and the United States, a “no” vote potentially seems more likely than not.
Should the “no” vote prevail, Italian political risks are likely to intensify. For starters, should Renzi resign as promised, it would likely usher in a care-taker Government and bring forward national elections from 2018 to next year. Based on current polling, moreover, there is a strong risk that the 5 Star Movement could be the lead party in any post-election Government. Note the 5 Star Movement’s current political aims include re-negotiation of Italy’s debt and a referendum on Euro-currency membership.
As seen in the chart below, Italian risks are already being reflected in a widening in the yield spread between 10-year Italian and German Government bonds.
Italy vs Germany 10 Year Yield Spread: 23 May 2016- 22 November 2016
Source: Bloomberg. Past performance is not an indicator of future performance
Adding to the potential European turmoil, it should be noted that both the Netherlands and France have national elections in March and April/May respectively next year, with a growing risk that populist “anti-EU” parties could take power in either country. Germany also holds its own national election in September, where immigration issues are likely to figure prominently.
Implications for the Euro and Equities
As should be evident, there is a growing risk that “Euro break-up” fears could again wash through Europe in coming months, which would have negative implications for the euro. A surge in political jitters, moreover, would make it even less likely that the European Central Bank will taper its quantitative easing program anytime soon. Somewhat perversely, however, a weaker Euro and ongoing ECB stimulus could aid European equities, particularly in the export power-house of Germany.