Can "Ita-leave" trump Brexit?
November 29, 2016
Unless otherwise noted, developments cited throughout this material are supported by data published by Bloomberg.
Securities markets are taking note of a wave of populism making its way around the globe, with developed economies lying in its path. In June, the outcome of the Brexit referendum defied analysts’ projections, only to be followed by Donald J. Trump’s election to the U.S. presidency in early November. Market observers are now asking, will Italy host the next populist outcry?
The question comes to light as Italian citizens prepare to cast their votes on a pro-growth constitutional referendum called by Prime Minister Matteo Renzi. Indeed, the stakes are high; if the referendum is rejected, Renzi has indicated he may step down. A strong “no” vote may also trigger a premature parliamentary election in the first half of 2017, instead of waiting for the scheduled election in the second quarter of 2018. Given these circumstances, it’s not inconceivable that the anti-European Monetary Union Five-Star Movement, which is currently running second in polling, could potentially have a chance to ascend to power — and bring the future of the monetary union into question.
A referendum on growth
In casting their ballots, Italian voters will decide on a referendum that seeks to refashion the legislative process so that obstructions to pro-growth measures can be minimized. The referendum calls for substantial changes in (1) how members of Parliament are appointed, (2) the powers they have once in office, and (3) the division of power between the state, administrative regions, and several administrative bodies. If passed, it will be the most extensive constitutional reform since the end of the Italian monarchy in 1946.
The referendum is playing out as Italy comes to terms with challenging economic conditions, marked by long-term stagnation of gross domestic product (GDP). The country averaged a GDP growth rate of 0.07% (quarter-over-quarter) from the first quarter of 2001 to the third quarter of 2016, compared with average growth of 0.42% from the third quarter of 1996 to the fourth quarter of 1999. The Five-Star Movement blames these anemic results on the country’s decision to join the monetary union. However, the argument can be countered by looking at the economic growth posted by other countries after they entered the union. Spain’s GDP growth, for instance, averaged 0.7% from the first quarter of 2004 to the third quarter of 2016, compared with 0.4% from the first quarter of 2000 to the fourth quarter of 2003.
To be sure, the Italian economy is tackling difficult structural challenges. The government’s debt burden, together with nonperforming loans within the banking sector, are two examples. Government debt approached 132% of GDP as of 2015, and has exceeded 100% since 1995. The banking system is contending with troubled loans that amount to one-fifth of total loans outstanding, accounting for roughly 40% of all sour loans within the euro zone. What’s more, an elevated unemployment rate — averaging 10.4% from 2009 to October 2016, compared to an average of 7.1% from 2004 to 2008 — reflects the fact that the Italian economy is largely made up of small, family-owned businesses that are losing market share to low-cost manufacturers based in emerging markets.
What the polls are saying, and what they could portend
Since September, polls have projected a strong likelihood of a successful “no” vote. If the referendum indeed fails, the anti-establishment Five-Star Movement may gain more support; and if that happens, the risk of Italy exiting the monetary union may rise. With that in mind, here is the range of possible outcomes that we are considering as voting day approaches:
- Base case scenario: A “no” vote with no early election, meaning that the government operates “as is” until the next parliamentary election in 2018. Financial markets are putting a significant probability on this outcome: The yield on 10-year Italian government debt has moved 30 basis points higher in November, compared with moves of 3.5 basis points and 11 basis points in German and Spanish debt, respectively. The yield difference between 10-year government debt issued by Italy and Germany is 213 basis points, the highest since 2014. (One basis point is 1/100 of one percentage point.) Year-to-date through Nov. 25, the MSCI Italy Index has declined approximately 25%.
- Positive scenario: A surprise “yes” vote, which could reverse the negative sentiment that has been coursing through financial markets. Italy’s government debt may rally, sending yields lower and perhaps reversing the selloff that began in October. This could also send Italian equities higher, allowing them to take part in the global upswing that followed the U.S. presidential election.
- Negative scenario: A landslide “no” vote. This would reinforce perceptions that the Italian government is unable to deliver reform, and parliamentary elections would be called in early 2017.
All eyes will be on the referendum as investors prepare for a range of possible consequences. How will securities markets behave? How will the fundamental outlook for Italy change? What are the potential spillover effects? These are among the questions we will consider as we continue our long tradition of incorporating political risk into our day-to-day investment decisions.
The views expressed represent the Manager’s assessment of the market environment as of November 25, 2016, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.
The MSCI Italy Index tracks the performance of the large- and mid-capitalization segments of the Italian equities market. It accounts for approximately 85% of the Italian equity universe.
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