Head Global Market Strategist
Global Fixed Income Strategist
Global Research Analyst

Analysis and outlook for the global economy

  • Italian Prime Minister Matteo Renzi announced his intention to resign, after his proposed constitutional referendum on political reforms failed with voters on Sunday by a large 60 percent to 40 percent margin.
  • Overall, the Italian referendum vote marks another gain for anti-establishment European political movements that oppose European Union leadership from Brussels.

What it may mean for investors

  • Italy’s failed referendum adds to ongoing European political and economic strains, but initial market reaction has been benign. Whether there are further negative impacts to Italian financial assets and the euro will depend on how political events evolve in the near term—notably, whether the country will see fresh elections or not.

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Keep Perspective on the Failed Italian Referendum

Italian Prime Minister Matteo Renzi announced his intention to resign, after his proposed constitutional referendum on political reforms failed with voters on Sunday by a resounding 60 percent to 40 percent margin. This was an especially convincing outcome given the high turnout of 65.5 percent of Italian voters. Nevertheless, international-market reaction was muted, with little significant weakness in Italian equities, bonds or the euro. We see at least three reasons why markets may have reserved judgment on the referendum result:

First, Italy’s “no” vote was expected. Moreover, while the margin of victory was larger than anticipated, much had already been discounted, with Italian 10-year sovereign yields trading as high as 2.20 percent in November, and the euro weakening to test its 2016 low around $1.05 per euro. If a “no” vote was already in the price, the expected outcome reasonably might produce some profit-taking.

Second, markets need to see what happens next. It is important to note that what we view as the most negative outcomes—early elections, the taking of power by the anti-euro Five-Star Movement, a referendum on euro membership in Italy—are still far from inevitable consequences of the “no” vote. After President Sergio Mattarella accepts Prime Minister Renzi’s resignation, Mattarella will likely try to form a “caretaker government” with a limited mandate to shepherd Italy through to the next scheduled elections in May 2018. If Matteralla succeeds in this, then the air of crisis may recede. However, if political infighting prohibits the formation of such a relatively technocratic administration (the kind that has served Italy well in past years), then there will be a risk of snap elections.

Third, bond and currency traders are acutely aware of the upcoming European Central Bank (ECB) meeting on Thursday, December 8. Too negative a market reaction to the ECB’s response to the referendum results in Italy (in the near term) may invite ECB countermeasures—or, at the very least, some forceful rhetoric from ECB President Draghi to in an attempt to stabilize markets. In this case, holders of overly bearish positions in Italian assets might suffer losses by any quick market turnaround. This is another reason for traders to err on the side of caution for now.

All that said many political challenges remain for European assets in the coming months. In Italy, there may yet be snap elections, a victory for the Five-Star Movement, and more talk of a referendum on euro-area membership. This could lead to more serious selling of Italian assets, not least in the banking sector. (Yet, we should note that even if the Five-Star Movement wins the next election, serious legal obstacles stand in the way of a referendum on euro membership. Additionally, a poll for La Stampa newspaper in Italy on November 21 indicated that only 15 percent of those surveyed favored leaving the single currency and 67 percent identified themselves as believers in the euro1.)

Also, more broadly, the Eurozone will face at least two more such election-risk events in 2017. These include the elections in the Netherlands in March, during which the far-right and anti-EU Party of Freedom is expected to gain seats in Dutch Parliament; and the second round of the French presidential elections in May, for which there is more than a tail risk of the strongly anti-EU Front National candidate Marine Le Pen gaining power.

Recommendations and Risks

Europe faces significant economic and political hurdles during the next several years, but we would not dismiss the current European economic recovery peremptorily. The current economic expansion has been resilient, and households and businesses are repairing their balance sheets. Labor-market reforms are progressing and, with low interest rates, support consumer spending. Our investment takeaways are as follows:

Negative yields make developed-market sovereign bonds unfavorable. Corporate bonds take some additional support from the ECB’s bond-buying program. However, on balance, the prospect for further currency depreciation creates an unfavorable outlook for European bonds. The euro may depreciate to the lower end of a $1.00-1.08 range by year-end 2017.

We remain neutral on the broad European equity market. Slight 2017 European earnings improvement is likely, while persistent negative sentiment seems to ignore the improving fundamentals and the basic support of aggressive monetary stimulus. Widespread improvement probably awaits a steadying in the European banking sector, a large sector that will need to show some growth if the economy is to gain steam.

Still, the Italian "no" vote is another warning of the ongoing rejection in Europe (and elsewhere) of establishment parties that had formed the post-war political consensus. We have highlighted the risk of early elections in Italy and that anti-euro parties may gain in Dutch and French upcoming elections. We would become more concerned about Europe as an investment destination if anti-establishment and potentially anti-European Union forces create further political and economic stresses within the Eurozone-stresses that could eventually provoke choices about future unity.

1 La Stampa Mondo: “Vogliamo ancora l’Ue, nonostante tutto”, November 21, 2016