Investment strategy: Italy says no to reforms

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The Italian people voted against reforms of the Italian Senate in yesterday’s referendum. Prime Minister Matteo Renzi offers his resignation, meaning that we are entering a period of political instability in Italy.

Unlike the results of the UK referendum and US elections, this outcome was in line with market expectations. Markets are therefore responding relatively muted. Early indications -before European markets opening- are a modest retreat in the euro and relatively stable Asian stock markets. This market reaction is small compared with what we saw right after Brexit and the US elections. 

We expect that Italian securities will continue to struggle in the near term, but fears for an Italian exit from the eurozone are overdone.

Political uncertainty reigns in Italy

We have entered a period of political instability in Italy. The referendum had morphed into a confidence vote on Prime Minister Renzi. He offered his resignation as soon as it was clear that the no camp had won by an overwhelming 60%. His resignation may open the door for a caretaker government and possibly  trigger early elections.

The latest polls show that an early election would sweep the populist and anti-euro Five Star Movement into power.  The same no vote, however, means that reforms to the Senate will not take place. As such, Italy continues to have a parliamentary system where the Lower house and the Senate enjoy equal power.  This effectively means that no single political party can dominate legislative power. Fears of an Italian exit from the eurozone may run high in the aftermath of this referendum, but are therefore overdone.

Restructuring banks now more difficult

The vote against reforms means a roadblock for the recapitalisation of banks with large non-performing loans, of which Banca Monte Dei Paschi di Siena is the most important. Private parties that previously had expressed their willingness to step in, may hesitate -or in the worst case- even step back. The Italian government may then have to bail out these banks. This is against the will of the European Union that insists on bailing in bond holders. All this will reduce confidence in Italian banks. 

Market price weakness may spill over to the European banks, but this may be more sentiment than fundamentals. In contrast to Italian banks, European banks have been able to strengthen their capital base over the last few years. 

S&P may downgrade Italy to a speculative rating

The no vote also means a halt to structural reforms of the economy which Italy desperately needs since its economy is flat-lining and the pile of debt is high. The bleak outlook for the government debt and the Italian economy may trigger credit rating agency S&P to downgrade Italy from BBB- to a speculative credit rating. 

S&P has had Italy’s credit rating on negative watch for some time. For now, the credit rating of Italy with credit rating agency Moody’s and Fitch is investment-grade with a stable outlook. Therefore, the wider implications of an S&P downgrade, if it were to happen, are fairly limited and not expected to be immediate.

Italian securities will struggle

Already in the run-up to the referendum, financial markets were leaning towards this no outcome. Italian government bond and equity prices had fallen behind their benchmark. 

The first market reaction following the outcome of the referendum is therefore relatively muted. The euro fell one cent to the US dollar overnight and Asian stock markets less than 1%. Still, we expect political uncertainty to remain a drag on the performance of Italian equities, government bonds and bank bonds. 

In the meantime, we will assess the opening of European markets and whether Italian weakness will spread across European financial markets. In case we adjust our investment policy, we will update you as soon as possible.


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