The 4 December referendum on Italy’s constitutional reform will decide the long term growth trajectory of Italy’s economy. If the Italians vote yes, bills on labour to pensions to industrial policy will more easily be passed speeding up the ambitious reform agenda of current Prime Minister Renzi and future governments. Domestic-demand growth will be reinvigorated. If the Italians vote no, it is status quo for the economy: moribund growth, weighed down by a slow-responding and ineffective government; high unemployment; and high debt, inciting populist rhetoric. Eurosceptic leadership will threaten the European project, with opportunities for anti-establishment parties to form a new government.
We discuss the potential political, and in turn, economic ramifications and share our thoughts on how investors could potentially allocate across major asset classes, ahead of the vote and in the aftermath – from both a strategic and tactical perspective.
Figure 1: Allocating on the 4 December Referendum
The constitutional reforms proposed
(1) Change the equal distribution of power in both houses of Parliament: by reducing the powers of the Senate (upper house) and increase powers of Chamber of Deputies (lower house) to:
+ speed up the lengthy legislative process where bills bounce back and forth between the upper and lower houses of Parliament and allow future reforms to be implemented faster.
+ stabilise governments. A confidence vote by the lower house is enough for the government to remain in power. Backing from the Senate may be sought but is not required.
+ slim down government. Number of MPs in the senate to drop from 315 to 100.
(2) Change the powers allocated to central and local governments: Cut overlapping powers between regional and central governments by redefining responsibilities and reduce, if not eliminate, provincial power. This to improve effectiveness and reduce bureaucracy.
(3) Change the electoral law: Seek strong majority premium by granting the largest party with more than 40% of the vote, 54% of the seats in the lower house and hence an absolute majority. This is to allow laws to be passed quickly, although absent a Senate’s veto to block them, would mean a parliamentary system with reduced checks and balances. It is by far the most contentious part of the constitutional reform, since parties both in the coalition government and in opposition sense opportunities and threats to the absolute majority premium granted.
Plenty of caveats in the polls keeps uncertainty alive and markets on edge
Latest polls and betting odds have tilted increasingly towards a no vote but the EU referendum in Britain in favour of leave and the surprise outcome of the US Presidential election showed polls to be unreliable and prone to contrarian outcomes. This could very well happen in Italy’s referendum owing to:
+ the mixed results of previous governments that tabled constitutional reforms in Parliament or called on referendums in the past.
+ a large undecided voter block that could tilt the outcome in either direction.
+ voter turnout and regional preferences: Historically this has been high in Italy’s northern regions and where a “yes” vote appears most likely, and low in the southern regions where a “no” vote is more likely. Furthermore, there are millions of eligible Italian voters living overseas, many of whom are believed to favour change but are not captured by the existing polls.
“Yes”: The economic “escape-velocity” trigger for sustained growth and less debt
An overwhelming majority of legislative powers to be handed to the Chamber of Deputies would reinvigorate the economic recovery, as reform bills in much needed areas such as the budget, infrastructure spending, the tax code, the pensions system and crucially the labour market should be ratified faster.
At the moment reforms are not radical enough to spur real change. Consider Renzi’s labour market reform dubbed the ‘Jobs Act’, which went into effect in 2015, to ease firing restrictions for big companies and offer temporary tax breaks for businesses that hire workers on permanent contracts. However, because it only applies to new hires, large chunks of the labour force such as the private sector workers already employed, and the 3.5 million public sector workers, remain unaffected. As such it will take years for these reforms to bring down unemployment meaningfully, time that politicians in Italy can ill afford if they want the country to remain in the Euro area.
The threat overhanging Italy as part of the Euro area is its large public debt. In spite of Italy’s tough austerity measures and primary budget surpluses, the debt repayment burden has overwhelmed the budget. As shown in Chart 1, over the last five years, the government has been saving close to 2% of GDP pa: To put this aggressive belt-tightening into context, the primary budgets as percentage of GDP in 2015 showed Italy (+1.6%), along with Germany (2.3%) and Austria (1.4%) to be the top savers at the state level in the Euro area but this has not been near enough to bring down public debt. With repayments of interest and principle hovering more than 4% of GDP pa Italy’s nominal GDP growth must exceed well over 2% in the future to outgrow new debt accumulation, assuming state savings remain the same. Unless growth accelerates and Italy emerges on an equally strong footing as its European peers (see Chart 2), government debt, stuck at over EUR 2.2 trillion, or 133% of GDP, will remain Italy’s and Eurozone’s Achilles heel.
The constitutional change becomes ever more pressing given that, without levers to reverse it, Italy has now become vulnerable to external shock beyond its control. For instance, the recent Trump victory in the US election which caused Italian long-dated bond yield to spike in November in spite of the ECB QE programme and will make future debt refinancing costlier. Added to Italy’s misfortune were the August and October earthquakes this year which, on top of the refugee crisis with the EU failure to stop thousands arriving on Italy’s shore, have burdened the finances to such a degree that Renzi is backtracking on its deficit targets.
Feeling the political pressure at home to produce economic results, Renzi in turn is adding pressure to the EU to backtrack on fiscal tightening, with his latest budget submitted in October proposing a raising of the deficit ratio to 2.3% from 1.8% to thwart the rise of populist sentiment at home. By behaving more populist both at home and abroad, Renzi is using his budget as a veiled threat against the EU, which looks vulnerable if Italy’s Eurosceptic Five Star Movement materialises as a political party on its own or part of a new government. There are additional knock on effects to fringe parties gaining further momentum against the mainstream parties in countries like France, Holland and Germany, all holding general elections next year.
Source: WisdomTree, Bloomberg
“No”: Status quo raises political and economic risks
Amidst growing frustrations of the electorate about the European fiscal compact, it is unrealistic – politically and economically – for Italy to go through more austerity than it already has. In this context, the referendum is potentially Italy’s last chance to enforce structural change. A rejection would deter future governments to attempt the same for years to come, implying an alternative route for Italy that in all likelihood means significant more deficit spending on the horizon. With Renzi already backtracking more on budget tightening, a precedent is set for any leader replacing him to accelerate fiscal stimulus.
The added major uncertainty overhanging the “no vote” is the potential power vacuum left if Renzi does resign and new elections are called. A real opportunity would open up for Eurosceptic parties such as the Five Star Movement and The Northern League to lead or to be part of a new coalition government. Under the leadership of the party’s founder Beppe Grillo in particular, the Five Star Movement would in all likelihood call for a referendum on the Euro.
In a scenario where following the “no vote” a populist party takes control, the initial reverberations in financial markets may be outright downbeat. The Euro is likely to come under sustained selling pressure as speculators bet on the end of Italy’s membership in the Eurozone and monetary union itself; we may see the return of the Lira, higher inflation and deficit spending. Bond yields of Italy’s long dated debt could resume their rise, driving the wedge between Italy and other indebted countries such as Portugal, Belgium and Spain on the one hand and Europe’s healthier core led by Germany on the other. At the epicentre are the Italian banks which, holding EUR 445 billion of government – mostly Italian – debt securities on the balance sheet, pose the biggest systemic risks for the Eurozone.
Banks: Systemic risks in banks rising anew
Since 2016, EU members, including Italy, must adhere to EU regulations that there will be no state aid to troubled banks unless bail-ins on equity and subordinated debt are imposed first, so as to reduce the end bill for taxpayers. The application of this “no bailout without bail-in” rule on bank rescues at the EU level means the bail-ins of four regional lenders this year have come at a huge cost to thousands of individual savers who, in addition to being account holders with them, typically also are investors in their bonds. Households and retail investors in Italy hold an estimated EUR 200 billion of bank bonds, which is a major obstacle for Italy’s government in dealing with the bank restructuring and will need to avoid potentially inflicting much larger losses to households and individuals. Efforts to recapitalise banks using private investor funds, off-balance sheet structures, cost cutting and consolidation have been insufficient to restore confidence. Seeing Renzi’s struggle and his popularity hit hard, future leaders of Italy will look to rely on state support as the only means to politically survive the storm.
The EU reaction on a “no vote”: Easing fiscal budgets, loosening bail-in rules, expanding QE
It is for these reasons that in the interest of preserving political stability, the EU is expected to approve Renzi’s budget and appropriate more fiscal stimulus further down the line by whoever leads the next government. France is also showing signs of being supportive, as it too is dealing with a refugee crisis which is starting to become politically taxing for President Hollande. The tough rhetoric on fiscal restraint from Germany and several of the northern countries in Europe is set to weaken as pressures from populist left-wing parties at home and the political union of Europe as a whole intensify.
A “no vote” outcome could potentially spur the EU into action in an effort to contain a rise of systemic risks – if Renzi resigns, political turmoil ensues, bond yields soar and the Euro comes under attack. There is reason to believe – if not out of economic sense, than out of self-preservation – that the EU, spearheaded by Germany, will double down on their tough stance on the restructuring of Italy’s banking sector and support a looser interpretation of the bail-in regime (ie more state-aid) in an effort to fast track the recapitalisation of the weakest banks. Unless more tax money is used to help banks recapitalise, the confidence amongst the bankers themselves along with that of investors, may start to sour in banks anew. Were that to lead to another freeze on interbank markets, Italy’s entire economy could seize up, the costs of which will by immense to both Italy and the European bloc.
The ECB will not sit idly by, either, as without the banks, the ECB has no mandate. The ECB, using expansive QE by raising and prolonging the month purchases, will try to curb rising yields on government debt and potentially recalibrate the bond purchases more towards Italian debt if necessary. Liquidity channels will also be thrown wide open along the way to make sure money markets and interbank lending are functioning, leaving no major bank high and dry.
Asset Allocation: A “yes vote” means bullish sentiment for most Italian asset classes and Euro
+ Restored confidence in Italian BTPs, which has been shaken following Donald Trump’s US election win, would potentially reverse the spike seen in November in Italian long-dated government bond yields. Political stability and a pro-growth agenda should mean improved fiscal conditions for Italy, along with likely endorsements from credit rating agencies reflected in a potential upgrade of Italian debt.
+ Italy’s banks are most likely to receive the biggest sentiment boost given the deeply depressed valuations, approximately at half their book values, at which their stock prices trade. Better long-term economic growth expectations would give Italian banks more confidence to extend new lines of credit and likewise businesses and households to apply for them. A faster expanding healthy loan book would work to speed up the reduction of banks’ non-performing loans.
+ With the market cap of the FTSE MIB index heavily tilted towards financials, it is interest rate sensitive. The banks, insurers and investment firms holding large allocations of Italian government bonds will likely benefit from a falling bond yields scenario. Furthermore the energy and utility sectors may benefit from government’s intensions to spur on privatisation as it seeks to cut its corporate shareholdings.
+ The Euro may potentially rise as stronger growth conditions for the economy, faster bank restructuring and political stability restore confidence in monetary union. Expectations of QE tapering by the ECB could help the Euro regain a lot of the value lost against the dollar and other currencies. Seen as a safe haven, gold is expected to react bearishly to such conditions.
+ European small cap stocks should benefit from upbeat investor sentiment and risk-on positioning around Europe’s domestic demand-led growth longer term.
Asset Allocation: A “no vote” means bearish sentiment for Italian asset classes and Euro
+ Spreads of BTPs over Bunds are prone to widen as a politically charged environment leaves no scope for budgetary restraint. Credit rating agencies may look to potentially downgrade Italy’s sovereign rating if deficit spending increases do not accompany structural reforms.
+ Souring sentiment on Italian debt would impact the banks negatively too, initially, as they are likely to book losses on the trading book and see interbank borrowing conditions deteriorate even as their own cost of debt rises.
+ Industrial equities in Italy may suffer from the government holding back on selling their stakes in a depressed risk sentiment environment. Strategic sectors may look prone to more government involvement and interference with populist left leaning parties forming the government.
+ Sentiment in the Euro is set to sour on Italy’s political instability in the short term, with speculation about Italy leaving the Eurozone if a Eurosceptic-led government pushed through a referendum on the Euro longer term. Expansive monetary and fiscal policies are likely to initially trigger further weakening, while further out, there will be stabilising driving forces for the banks and the real economy.
+ Longer term, European exporter stocks should benefit from a Euro devaluation to the extent that it is controlled and not feeding into outright risk-off positioning by investors. The likelihood of high volatility of the Euro should compel foreign investors seeking exposure to Europe to potentially hedge their equity exposure, while financials in this context are seen as the sector to be underweighting.
Tactical allocations using our range of Boost Exchange Traded Products
Strategic allocations using our range of WisdomTree UCITS Exchange Traded Funds