Last night, the Italian Government was heavily defeated in a referendum over changes it had proposed to the country’s constitution. This led to the resignation of Prime Minister Matteo Renzi and has thrown significant uncertainty over the country’s political future.
Italy’s president has begun the process of selecting a new prime minister to form a caretaker government, although this will likely have limited scope and power because of the circumstances under which it will be formed.
Given the defeat, the populist opposition parties Movimento 5 Stelle (Five Star Movement) and Lega Nord (Northern League) are likely to push for elections to take place imminently, with some believing that a vote could take place as early as the beginning of next year. If it does and a populist party emerges victorious, it would signal a change in Italy’s political status quo similar to that which Brexit and Donald Trump’s election have done in the UK and US.
Under such circumstances, it is likely that Italy will hold a non-binding referendum on its European Union membership. This could cause a considerable rise in volatility in European sovereign bond and currency markets, as questions over Italy’s secession from the currency bloc would throw significant uncertainty over its ongoing sustainability. We note that polls show Italian voters are currently keen on staying in the European Union, but this was also the case in the UK before its referendum in June.
This morning’s market reaction
The immediate market reaction was borne mainly by the euro, which fell about one percent to new yearly lows against the US dollar. However, at the time of writing this morning the European currency has bounced back amid a pick up in risk sentiment and broader selloff in the dollar, with the major European stock markets all now in positive territory. Likewise, sovereign bond markets opened sharply down this morning, but these have also staged a recovery with ten-year yields in Italy up just 0.07% to 1.97%.
In yesterday’s other major political event, Austria’s Government achieved an unexpectedly strong victory in the country’s general election, evading a significant challenge from the anti-EU Freiheitliche Partei Österreichs (Freedom Party of Austria) and providing a boost to pro-European political parties across the eurozone. However, with the Dutch, French and German elections taking place next year (planned for 15 March, 23 April, and after 27 August, respectively), we expect European politics to continue to drive investment markets as we move into 2017. If anti-establishment parties gain traction in any of these countries, questions over the eurozone’s existence could put significant pressure on European assets, including the euro, with wide-ranging consequences.
Although ‘kicking the can down the road’ has been the policy of many European policymakers in recent years (think ‘Grexit’), this may no longer be possible if voters demand immediate systemic changes (such as EU secessions). It is yet to be seen if the European Central Bank and its Outright Monetary Transactions programme would be able to provide stability in the face of such events (although we are reassured that the Bank has gained significant experience in tackling market panics since the global financial crisis a decade ago). In any case, 2017 could end with significantly different European geopolitical and economic backdrops. Given that we saw political risk as heightened, we have held reduced exposure to Europe for some time and with many risk events forthcoming we do not yet believe it appropriate to change this stance.
This article was first published by Brookes MacDonald on 5th December 2016.