Has Italy Crossed the Rubicon?
The decision by the Italian electorate to vote No in yesterday’s referendum on constitutional reform has numerous ramifications. In the short term, yields on Italian government bonds are likely to soar while spreads against other major European bonds will continue to widen. Volatility will increase, not just in Italy but across Europe. Further down the road, there is also the possibility that Italy could be downgraded by the ratings agencies, precipitating a rise in its borrowing costs.
Most worryingly, the No vote could exert a baleful influence on the ailing Italian banking sector, where banks such as UniCredit, Banco Popolare and, in particular, Monte dei Paschi di Siena have been under intense pressure all year due to their non-performing loans.
It’s important to remember, however, that the referendum was not about Italy’s continued membership of the European Union—although it has been interpreted as such in many quarters. Prime Minister Matteo Renzi was seeking to expedite the political process by limiting the power of the Senate and ensuring the Lower House becomes the primary legislative body. His initiative received both internal and external support from domestic politicians and international organizations such as the OECD. Indeed, in a 2015 report, the latter observed that “Institutional reforms [in Italy] can be the basis for better policymaking and stronger implementation.”
Opponents, meanwhile, argued that this removed important checks and balances—and their vote carried the day. Rightly or wrongly, the market will likely view this as another example of the growing anti-establishment trend.
So what happens next?
With Renzi's resignation, there could be an early election, although the next one does not need to take place until 2018. It’s more likely that there will be an interim period during which the Italian president, Sergio Mattarella, appoints an interim 'technocratic’ government or one run by another leader within the PD (majority party).
From a market perspective, we believe the No vote will reduce confidence in the recovery of the Italian economy. It will also likely increase uncertainty stemming from rising euro scepticism across the euro area. Indeed, it will likely negatively impact Italian government bonds and risky assets in Europe.
As we saw after the U.S. election and the Brexit vote, however, markets could fully price these developments sooner than expected and reach oversold levels. We believe patience is key and that there may be opportunities to use any substantial sell-off to buy attractively priced assets.
More generally, Europe has struggled to deal with stagnant economic growth, foreign policy issues and the migrant crisis, but we still believe that in time it will deal with them. Indeed, our base case scenario is that Europe will continue to recover, albeit very slowly.
When Julius Caesar marched his army across the Rubicon in 49 BC, he famously declared “alea iacta est”—the die is cast. That’s not quite true of modern-day Italy; it can still shape its own future, but it needs to act quickly and decisively.
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