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Markets mostly “Meh” Response to Italian Referendum Vote is a Mistake

Markets mostly “Meh” Response to Italian Referendum Vote is a Mistake

Sunday marked the third time in less than five months that we’ve had a major political event trigger a market response. The outcome of the first of such, Brexit, took the market by surprise and caused major declines across much of the global financial markets. However, after having gotten himself into quite the tizzy, Mr. Market shortly decided, “Ehhh, maybe not such a bad thing,” and the market not only recovered but climbed higher in the ensuing weeks.

The second event was the Trump surprise. Initially, the major U.S. market indices plunged so far, so fast on Election Night 2016 that overnight futures trading had to be halted. Once again Mr. Market recovered from his meltdown and in a matter of hours, decided that not only was this not such a bad thing but decided to launch one epic rally heretofore called the Trump Trade.

Sunday the Italian referendum came in as expected with the “No” vote prevailing, so unlike the prior two, no surprise here. As for Mr. Market’s reaction, well he looks to be a bit worn out from all the drama since June and outside of Italian bank stocks, things are relatively calm.

Who would have guessed it would be the Italians to delivered non-drama drama while the stiff upper lip Brits delivered a meltdown? It also snowed in Hawaii over the weekend, go figure.

For as much as Mr. Market overreacted to the U.K. surprise, we think he is, at least in the long run, underestimating the magnitude of Sunday’s vote.

Safe to say that the Italians have given the world a very clear message that reforms, as much as they are desperately needed, are unlikely to see the light of day given the utter mistrust Italians have for their government, regardless it seems of who is manning the helm.

There could be some peppiness from the Austrian election which saw the nationalistic and vocal anti-EU candidate lose out to the Green Party candidate, who ran as an independent, giving us the first non-populist vote this year, but most likely the lack of drama is tied to faith in central bank incursions. A recent Bloomberg News poll of economist found a whopping 89% expect to see the European Central Bank extend its quantitative easing plan, both in magnitude and duration. The one move we see that directionally does make fundamental sense is the rise in Italian bond yields, up some 13 basis points versus the rest of the region rising in the 3 to 6 basis point range.

Granted, we’ve also seen some evidence in increasing economic health, with the Eurozone services/manufacturing PMI composite improving to an 11-month high of 53.9 in November from 53.3 in October. Despite Mr. Market’s initial Brexit panic, the U.K. service sector PMI rose to a 10-month high in November of 55.2 up from 54.4 in October. But that’s not Italy, which is the third largest economy in the European Union and the eighth largest economy in the world with the second highest debt-to-GDP ratio; the crown in that race belongs to Greece.

Italy’s banking sector is in crisis. This vote came right as Banca Monte dei Paschi di Siena (say that five times fast) is deep in recapitalization efforts, which could now be thwarted. If that happens and a solid government-backed rescue plan isn’t immediately presented, we are back in contagion mode that could easily spread outside to Germany’s beleaguered Deutsche Bank, which lost 90% of its market cap over the past ten years and 35% this year alone. Meanwhile, Eurozone finance ministers are meeting today in Brussels to assess the second bailout plan for Greece to determine if it is solid enough to warrant the release of the next tranche of funding. We’re taking the odds there will be a large uptick in Brussels minibar tabs this week.

Italy has an estimated €360 billion in nonperforming loans and a government debt-to-GDP ratio of 133%, so a bailout isn’t exactly a walk in the park.

Italy is one of the six founding members of the European Union and has traditionally been one of its most enthusiastic supporters, but that is changing profoundly and for good reason. Since the financial crisis has lost over twenty-five percent of the industrial production and youth unemployment stands at almost forty percent in a deflationary economic environment that is only increasing the nation’s already cumbersome debt burden. Waiting in the political wings upon Prime Minister Renzi’s crushing defeat this weekend are the anti-European Union Five Star Movement and Lega Nord. As the Italian economy struggles, these populist movements are gaining traction and stirring up more anti-euro sentiment.

While Italy’s economy is stagnating its political center is disintegrating, making reforms all the more challenging. It has very few other tools at its disposal with no ability to implement monetary stimulus and its already high debt load limiting fiscal stimulus options. If the nation can’t get its economy going, an EU bailout would likely require so much money that it would likely trigger a political revolt in Germany’s parliament. That’s the same German parliament that is facing an election next September.

If Italy cannot get its economy moving, and the realities here paint a picture with feeble hope, we could easily see pressure mount for it to leave the Eurozone both from within and outside the country. While Brexit involves messy renegotiations, it doesn’t threaten the single currency. An Italy exit, on the other hand, could not only threaten the currency but unleash a financial crisis in the region.

On any one day, Mr. Market tends to be rather shortsighted. We suspect when it comes to this referendum, the Italian drama is just getting started.


Italy’s referendum has the potential to set off a global landslide

Italy’s referendum has the potential to set off a global landslide

While financial, industrial and small cap stocks in the US have been partying like it’s 1979, investors would be wise to take more than a passing look across the Atlantic at Europe’s next biggest threat.

You’ve probably seen commentary about Italians voting on a constitutional referendum; not exactly riveting material.

Italy, Europe’s fourth-largest economy, is a nation in desperate need of reforms, having underperformed its major trading partners for decades, with the latest per capita GDP below 1997 levels and metropolitan area employment levels well below those in most of Europe.

Obviously, change is needed, but what is this referendum, why do you care and what is the herd getting wrong?

If you google the topic, you can get endless details on the vote, but here are the salient points. The Italian nation in its current form was born right after WWII and as such, has a deep-seated fear of concentrated power; pretty understandable after the fun times under Mussolini and his buddy Hitler.

That fear created a government with essentially two congressional bodies, both like America’s House of Representatives, except with more than double the members and even more layers of government from the top federal level on down to localities. There are a lot of people whose entire raison d’etre is to express their opinions and these are Italians, so the whole thing takes longer and is more emphatic.

The intention of the measures in the referendum, according to Prime Minister Mario Renzi, is to make government less complex and more functional, with fewer people involved and fewer layers. For example, today the Chamber of Deputies (Congress) has 630 members, (elected by voters age 18 and older) and the Senate has 350 members, (elected by voters 25 and older). The Senate would be cut to 100 members appointed by the regional elected governors, rather than by voters, and would only be involved in major decisions such as war or international treaties versus today where both houses basically participate in everything equally. The province layer of government would be officially removed.

David Cameron

Britain’s Prime Minister David Cameron wipes his eye as he addresses a news conference during a European Union leaders summit in Brussels March 20, 2015. REUTERS/Francois Lenoir

There’s more to it, but that gives a general sense. This bill is vast and complex, making a vote on it challenging as voters are unable to decide between the changes they support and those they don’t; it is all or nothing.

The bill was originally introduced by Renzi and his center-left party, then voted on by the Chamber and Senate twice. Yes, twice. It is now being put to a general vote by the electorate, illustrating the challenges of getting anything done in Italy’s government.

When it was first introduced and discussed, Renzi was enjoying more support than he is today, which led him to make the same mistake made by former UK Prime Minister David Cameron with Brexit, by making passage of the bill an endorsement of him. Back then Renzi vowed he’d not only resign, but would give up his political career; talk about laying it on thick. Recently Renzi has tried to soften his rhetoric, but most think that in the public’s that mind ship has long since sailed, so it would be tough for him to renege on those vows.

A man walks on a logo of the Monte Dei Paschi Di Siena bank in Rome, Italy September 24, 2013. REUTERS/Alessandro Bianchi/File Photo

A man walks on a logo of the Monte Dei Paschi Di Siena bank in Rome, Italy September 24, 2013. REUTERS/Alessandro Bianchi/File Photo

Opponents claim that a “yes” vote would give Renzi excessive power, which when you think back to the 1930s and 1940s, gives anyone in that part of the world understandable heartburn. While many are likening this vote to Brexit and Trump, the dynamics here are materially different. Brexit was primarily a, “Screw you!” to the status quo and bureaucrats in Brussels. Trump stormed into D.C. amongst cries of “Drain the Swamp!” Many are looking at the polls in Italy today, which indicate a “no” vote majority, and likening them to the inaccuracies of the Brexit and Trump predictions – that is a mistake.

The truth is at this point, most Italians don’t really even understand what the referendum is all about and Beppe Grillo, the leader of the Five Star movement, is helping to give voters the impression that a “yes” vote would give Renzi near-dictatorship powers.

Those Italians who understand that red tape is the biggest enemy of the country would vote “yes” over and over again. The problem is that those that would vote “yes”, tend to be better educated and higher income earners, which has given this vote a vibe of class warfare. With many of Italy’s business elite thinking that Renzi may be Italy’s last hope, that schism is visible to most everyone.

The Importance of this Referendum on Worldwide Markets

Investors need to care about this because the market has decided that this vote is an indicator of Italy’s ability to make much-needed reforms and that matters because of the impact of Italy’s banks and sovereign debt. The actual quality or validity of the reforms proposed in the referendum have become almost meaningless. For those within Italy the vote has become a referendum on Renzi and as Italians grow increasingly frustrated that their lives haven’t materially improved, even some members of Congress from within Renzi’s own party who originally voted for the referendum are now scrambling to develop compelling arguments for why they now oppose it.

Italian banks are in a world of hurt, which is almost intuitive if you look at the nation’s credit markets and weak economy. Italy has negligible public credit markets, so borrowing means a trip to the bank, which makes credit risk more highly concentrated than in countries like the US, which have robust bond markets. During the financial crisis and in the years following, banks engaged in a lot of extend-and-pretend, some of that of their own volition, some after cozy chats with government officials, hoping that at some point in the not-too-distant future, the economy would get back on its feet and those struggling loans could be made good.

Despite a rapid procession of new leaders, the economy has yet to recover. Granted, it is better today than in 2012, with a few new stores popping up here and there rather than seeing yet another one shut down week after week. The unemployment rates for younger Italians, however, remain tragic and intense frugality is more the fashion than Milan’s latest catwalk. Businesses remain weak, so borrowers and banks that made those loans are still struggling. Adding to the pain are the piles of sovereign bonds warehoused at banks and the even more painful dirty little secret that the Italian government is notorious for not paying its own bills. This creates a twisted triangle between the bank pressuring companies to pay their debts, those companies, in turn, trying to collect from the government and bureaucrats dialing up the banks for leniency towards those the government owes.

The Shake Out From this Vote Will be Felt Worldwide

Beppe Grillo

Leader of the Five Star Movement and comedian Beppe Grillo.REUTERS/Remo Casilli

If contrary to the polls the “yes” vote wins, Italian bonds and banks will rally and the MIB (Italian stock index) will have a huge relief rally, particularly given its over-exposure to banks, and the euro will likely strengthen relative to other currencies.

If the polls are right and we see a “no” vote by a large margin, Italian yield spreads over German bunds will widen a lot. Italian bank stocks will accelerate downward and Banca Monte dei Paschi di Siena (MPS) will likely need external aid, which will put the European Central Bank in the hot seat,  and all eyes will be on German Chancellor Angela Merkel who is also watching Germany’s Deutsche Bank spiraling downward.

Renzi will be pressured to resign, (unless the win is by the smallest of margins) and the Italians will find themselves back at the polls, with the outside chance that Beppe Grillo’s Five Star could gain additional traction, which would be terrifying for anyone doing business in the region. The euro will weaken materially. European banks as a whole will likely take a hit and the dollar will get pushed further and further up as money races out of increasingly dicey Eurozone into the relative safety of the US dollar and US assets – a tailwind to US stocks and bonds. The Italy economy would slow further thanks to the increased uncertainty, which would bleed over into other European nations and global trade. The acceleration to the rising dollar headwind facing US multinationals could render the Fed’s rate hike decision irrelevant in comparison and harm growth back in the States at a point when the economy looks just finally be gaining a bit of traction.

While it may seem like a minor event on the global stage now, history is full of moments that initially seemed of little importance, but like the final grain of sand that ignites a landslide, in retrospect, those moments changed the global landscape in ways that were previously unimaginable.