You may think that the UK Brexit vote was the biggest event risk of 2016 but, in our opinion, you could be wrong. We are much more worried about the constitutional referendum in Italy on Sunday 4th December, more so than a Trump win or a Fed rate hike.
Why so? Well, Brexit is turning out to be a local affair and will also be something of a slow burner. It may be some while before Article 50 is invoked and, even then, negotiations are sure to drag on. In contrast, a No vote in Italy could be the start of withdrawal from the euro and, stretching the imagination a bit, lead to the fracturing of the European Union.
The reforms being sought are the most sweeping since the second world war and seek to diminish the size and power of the Senate so that the government can govern. In recent times, Italian governments have been short-lived and achieved little.
However, prime minister Matteo Renzi has taken two risks. First, he has turned the poll into a personal popularity contest in saying he will resign if the outcome is No. Second, as David Cameron found out, referenda tend to become hijacked by off-topic issues. In theory, constitutional reform looks sensible but the poll could turn into a protest vote, thanks to weak growth, a troubled banking sector and a migration crisis in southern Italy.
In addition, the referendum may galvanise vested interests which benefit from the status quo. Big business groups such as Confindustria are in favour so it is likely that trades unions will be against. Latest opinion polls show the outcome is too close to call.
What might be the implications of a No vote? One, increased political uncertainty. Having staked so much on this vote, Mr Renzi is likely to resign. There could then be a stop-gap technocratic government until new elections in 2018. If electoral reforms passed earlier this year are also struck down by the Constitutional Court, then Italian politics will be in big trouble.
Two, slow growth and high deficits. The government downgraded its growth forecast yesterday to just 0.8% in 2016 and 1% in 2017 which in turn implies a higher budget deficit than previously thought and less room for fiscal stimulus.
Three, wider bond spreads and weaker equity prices. The spread between ten year BTPs and bunds is currently 133 bps, up from an August low of 113 bps and reflecting some political risk. During the eurozone sovereign debt crisis, the spread peaked at over 500 bps so the markets are not under stress at these levels but that could change in the event of a No vote.
However, the equity market has under-performed this year. It is down 22.6% year-to-date compared with a decline of 6.9% in the FTSE Eurotop 100 index. Partly this is due to Italy’s banking woes but we think it may also reflect political risk. European equities are relatively cheap but investors should be wary of the Italian market for now.
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