Italians Vote ‘No’: Implications for Italy, the Euro Area and Global Markets
By Todd Mattina, Chief Economist and Strategist, Mackenzie Asset Allocation Team
Todd MattinaChief Economist
On December 4, 2016, Italians voted ‘No’ in a constitutional referendum that many voters interpreted as a vote of confidence in Prime Minister Matteo Renzi’s government and Italy’s place in the Euro Area. Renzi resigned after approximately 60% of Italians rejected constitutional reform. The resounding defeat sets the stage for heightened political uncertainty in Italy, the Euro Area’s third-largest economy.
The ‘No’ vote shines a light on Italy’s troubled financial sector and highly indebted public sector with total debt of about 135% of GDP. The increased political uncertainty risks sidelining urgently needed reforms, such as recapitalizing the banking system and modernizing the sluggish Italian economy.
Markets quickly recovered losses after an initial selloff and flight to safe haven assets, as the referendum outcome was widely anticipated. The negative economic fallout from the ‘No’ vote is expected to focus mainly on Italy at this stage, with limited international spillovers. Looking ahead, we remain neutral on the euro relative to the loonie and modestly underweight European stocks relative to Canadian equities.
In the immediate aftermath of Italy’s referendum, here is our analysis of several key issues for Italy, Europe and global financial markets:
- The euro initially fell relative to the U.S. dollar, sinking to its lowest level in 20 months at 1.0506 before rebounding to over 1.07.
- Safe haven assets, including gold and the Japanese yen, also rallied before giving back initial gains later in the morning after the vote.
- The Italian 10-year government bond rate jumped by about 12 basis points compared to 7.5 basis points for German bunds.
- Italian stocks under-performed, falling by about 1.3% while other major European markets gained by 0.7% to 1.3%.
What happens next?
- Renzi resigned as prime minister, setting the stage for renewed political instability. He has ruled out leading a caretaker government.
- The Italian President is expected to invite a technocrat to form a caretaker government until scheduled elections in February 2018, although many expect calls for early elections in 2017.
- The latest polls suggest the populist Five-Star Movement, which opposes the euro but not necessarily EU membership, remains one of the top two parties in Italy.
Italy’s troubled banks
- Italian banks carry €360 billion in troubled loans, hindering their lending capacity and leaving many weakly capitalized.
- Renzi led efforts to rescue Monti dei Paschi di Siena, Italy’s third largest and oldest bank. Efforts to raise €5 billion in fresh private capital may now fail, raising the prospect of nationalization to prevent broader deposit flight from Italian banks.
- Italy’s banks remain vulnerable to a confidence crisis, which could provoke another Euro Area banking crisis in an extreme scenario.
Future of Europe
- The referendum was seen by many as a litmus test of nationalist and populist sentiment in Europe after the Brexit vote and Donald Trump’s election.
- The outcome may energize anti-establishment and populist political parties in Italy and across Europe.
- However, the Italian referendum was not a clear vote against the euro. Polls suggest most Italians remain committed to the euro and European integration.
- Many pro-Europeans opposed the referendum, including many members of Renzi’s own party.
- Over the weekend, Austrians voted for the Green Party candidate over the far right nationalist party leader for president, providing comfort to establishment parties.
ECB policy and financial sector supervision
- Italian households hold €160 billion in bank debt. According to EU rules, they must take losses before taxpayer funds can be used to rescue troubled banks (with indemnification of up to a maximum of €100,000).
- The ECB is likely to step in if systemically-important Italian banks experience rapid deposit flight or funding pressures, such as an abrupt jump in credit spreads.
- From a longer term valuation outlook, the euro is attractively valued. However, market sentiment remains weak and macro conditions are not highly supportive, including the prospect of increased ECB stimulus. Overall, we remain neutral the euro relative to the loonie at current levels.
- European stocks look unattractive at current levels so we maintain a modestly underweight position. Market sentiment remains highly negative, more than offsetting modestly attractive long-term valuations.