Italian prime minister Matteo Renzi has stepped down after voters blocked constitutional reforms that would have changed the composition and powers of Italy’s parliament in a closely watched referendum.
Renzi's Democratic Party proposed changes designed to give more power to reform the Italian parliament and streamline the country’s decision-making process, but it met stiff opposition from other political parties – especially the populist Five Star Movement and anti-immigrant Northern League.
At the time of writing, 59.11 per cent of more than 33 million votes cast had been against the proposed constitutional changes.
Some forecasters had warned of the potential negative impact of a ‘no’ vote for the Italian economy, while investor concerns have driven an increase in net notional value of credit default swap contracts for Italian sovereign debt compared with a year ago.
Indeed, fixed income markets had weakened in the run-up to the election as uncertainty surrounding the result had grown.
Italian 10yr+ bond performance vs European government 10yr+ performance
Source: FE Analytics
Maria Paola Toschi, global market strategist at JP Morgan Asset Management, says Renzi and his government had suffered a vote of no confidence from the referendum, which was a key component of its reform agenda.
“It’s too early to make predictions about the consequences of Renzi’s resignation. This reformist government ultimately didn’t overcome the high resistance of people to changes and the suspicion versus the political establishment,” she said.
“However, it may remain unlikely the country calls for a snap election, given that political parties it will now need to re-examine the electoral law as an indirect effect of the rejection of Senate reform.
“The most likely outcome is therefore that the president of the Italian Republic will give a mandate to a candidate to form a new government, a very lengthy and complex process with a prolonged period of uncertainty, with negative implications for the Italian economy.”
Despite the potential to cause further political uncertainty in a key eurozone economy, reaction to the referendum in markets had been subdued.
Rating agency S&P Global Ratings said the outcome of the result had no impact on Italy’s sovereign rating, which remains at BBB-, one notch above non-investment grade status.
“From the perspective of political stability and effectiveness, we believe that the proposed reform would have had potentially positive benefits,” it noted. “Nevertheless, the negative outcome of the referendum yesterday does not have an immediate impact on Italy's creditworthiness as it does not have immediate implications for Italy's economic or budgetary policies beyond likely near-term changes in Italian politics.”
David Simner, fixed income portfolio manager at Fidelity International, says the reaction of bond markets suggested that a no vote had already been priced in.
“While Renzi’s resignation may come as a surprise at the margin, the chances of early elections remain slim at this point,” he said. “The base case is that a caretaker government will be appointed in the next few days, something that Italy has already had experience with in the past.
“For Italian fixed income, the key date remains the European Central Bank [ECB] meeting this Thursday 8 December, where we expect an extension of the QE programme by at least another six months after March 2017.”
“The ongoing ECB support to European government bonds makes any meaningful widening in BTP [Italian government bond] spreads unlikely in our view, and a higher market uncertainty will support a dovish stance by the governing council. We would therefore see any sell-off in peripheral government bonds as a buying opportunity.”
One of the key concerns for investors will be the health of the Italian banking system, which has continued to struggle under the weight of non-performing loans and increased capital requirements in recent years.
Performance of Italian bank stocks vs Europe ex-UK banks since June 2008
Source: FE Analytics
“As before, the key risk for Italy is its banking sector which remains under-capitalised and under-profitable,” said Philip Dicken, head of European equities at Columbia Threadneedle Investments. “The necessary recapitalisation of the banking sector will be made harder by a prolonged period of political uncertainty.
“The first test comes this week, when the architects of Banca Monte dei Paschi Siena’s capital-raise must decide whether to push ahead with their plan to raise a further €4bn [£3.4bn] through equity issuance. If that deal is pulled, the recapitalisations of a number of other troubled banks may be thrown into question. The recapitalisation of the banks is essential if Italy is to escape its cycle of low growth.”
“Financials remain in the crosshairs, and investors will keep a close eye on the implications that the ‘no’ vote will have on the upcoming recapitalisation exercises by Montepaschi and Unicredit,” added Fidelity’s Simner.
“We expect volatility ahead, until more details become available. However, it will be equities, rather than fixed income investors, who will bear the burden of further rights issues on the horizon. We therefore remain comfortable with our positive view on Italian financials, particularly on the large national champions, who will continue to benefit from a stronger capital position, improved profit margins and a larger market share.”
The potential for further uncertainty does pose some concerns for investors. The UK Brexit referendum result and the rise of populist political movements elsewhere in Europe has heightened investor cautiousness in recent months.
Michael Metcalfe, global head of macro strategy at State Street Global Markets, said: “Markets were uncertain about European political risk before the vote and now they will be seriously unsure. The no vote increases the chances of an Italian election in 2017, which given the popularity of the Five Star movement and their views on Europe, means that Italian assets will now attract an additional risk premium.
“The only potential good news in the near term is that, partly in anticipation of this result, Italian equities and bonds have already underperformed significantly in the past month. The euro itself is likely to weaken further, however, with the prospect now of four major elections next year, most of which have the potential to surprise or produce disruption.”
Although there are significant political headwinds for Europe in the year ahead, some are maintaining a less bearish outlook for the broad global economy, particularly given the strength of the US economy since the election of Donald Trump.
“From a multi-asset perspective, we’ll keep a cautious view on Euroland equities as headline risks are still high amidst the crowded political agenda,” said Monica Defend, head of global asset allocation research at Pioneer Investments.
“However, we believe that this result will not derail our constructive outlook for 2017, with potentially higher growth and higher inflation on the radar globally.”