Olly Russ weighs up the likely outcome of the unusually complicated referendum question being put to the Italian population this weekend and what that could mean for markets
The key question in European investment at the moment is of course ... deep breath ... "Do you approve the text of the constitutional bill concerning ‘Dispositions for the surmounting of perfect bicameralism, the reduction of the number of Members of Parliament, the reduction of institutional operating costs, the abolition of CNEL and the revision of Title V of Part II of the Constitution', which was approved by Parliament and published in the Gazzetta Ufficiale n. 88, on April 15, 2016?"
No, this is not taken from a particularly fiendish Politics exam, but the actual question being asked in the Italian referendum scheduled for this Sunday. For those who have misplaced their copy of the Gazzetta Ufficale n. 88, the referendum is designed to give popular approval to important constitutional reforms already approved by Parliament.
Essentially, successive Italian governments - and they have certainly tried a few: more than 60 since 1945 - have been unable to reform, partly because of the structure of the system. There is a lower house, equivalent to the UK House of Commons, and an elected Senate, akin to the House of Lords. Since the Senate is also elected, however, it has equal power to the lower house, requiring a majority in both houses to pass legislation.
Matteo Renzi, the reforming prime minister, has decided effectively to abolish the Senate in its current form, restricting membership to 100 appointees from the regions, while also reducing the power of the regional assemblies to dissent from central government legislation. In other words, this is both a streamlining and a centralisation of power.
While the Italian economy absolutely requires this reform as a necessary first step to a similar reform of the economic system, the lesson of referenda is that few people concentrate much on them until the final two weeks. Now all eyes are on Italy and the aforementioned question.
The polling industry has not had its best year in 2016, with its predictive power post Brexit, Trump and French primaries now seen as somewhere between that of soothsayers, astrologers and economists. Still, it has to be said the chances of a ‘Yes' to the referendum question are drifting out.
From a strong ‘Yes' position in the spring of 53.2% to 46.9% ‘No', the polls have seen a steady drift to ‘No' - now itself rated at 53.1% versus 46.9%, an almost perfect reversal of fortune. Nonetheless, 26.4% of voters remain undecided. We are unable to rehearse here a full summary of the political debate for reasons of space and life expectancy, but this is not a simple Right versus Left issue.
What is more, if we think the anti-establishment vote is likely to win, it is not easy to identify which side that is. A proposal to sack several hundred politicians hardly sounds traditionally pro-establishment. There is a feeling perhaps that the ‘shy' vote is for ‘Yes', and turnout will likely be higher in the North which is also more pro-‘Yes', but the expectation is the proposal will fail.
Potential market outcomes
In the event of a surprise ‘Yes', there is a high degree of probability of a strong market rally. With the French and German indices essentially flat year-to-date, Italy stands out, being down more than 20%. Of course, much of this is due to the ongoing banking crisis in Italy, but it is also due to uncertainty around the referendum result - and there is nothing the markets like less than uncertainty.
The CEO of the Italian exchange reports there are currently ‘colossal' short positions on the Italian market - positions which may well need to be closed in the event of a surprise ‘Yes'. But why does a domestic political reform attract such attention from hedge funds? Essentially, Renzi has massively increased the stakes by promising to resign if he loses the referendum, leading to more uncertainty and a potentially severe bout of political instability.
If does tender his resignation to the President, there are several different scenarios that may develop:
* After a face-saving resignation offer, the President refuses to accept it, or Renzi is reluctantly persuaded against his personal wishes to remain as PM (or as head of an expanded coalition ‘Renzi II'). This is known as the Nigel Farage gambit.
* A caretaker government is installed under a technocrat, in the style of Mario Monti (PM 2011/13) until new elections are called, probably in 2018.
* The President dissolves Parliament and announces a general election.
Of those options, a severely adverse market reaction is probably only likely in the third scenario. There has been much speculation recently that the anti-Euro Five Star movement might win an immediate general election, and then potentially unleash a referendum on Italian euro membership.
A side-issue of the current referendum is that Italy has already passed the so-called Italicum Law, which is designed to give a guaranteed majority to the biggest party in Parliament at the next election. Since Five Star refuse to co-operate with other parties, this is the only way they could exercise power, short of a massive surge in support. The Italicum law is very controversial, and will most likely be changed before the next election in a way that favours the winning coalition (a policy seemingly primarily designed to exclude Five Star from power).
The nightmare scenario therefore of immediate elections leading to a Five Star government with unfettered power is therefore very hard to see in practice. Remember that in this situation the Senate would still be in place with full blocking powers, and the legal challenges to an Italian euro referendum are immense.
Last, but by no means least, the President has already announced he would personally prefer the government to continue in office, and for elections to take place on the expected timetable in 2018. Since the ultimate decision on this is his alone, this is a fairly powerful statement against immediate chaos.
Ongoing banking crisis
Much of this would be largely an irrelevance to markets outside Italy, were it not for the economic backdrop -most especially seen in the ongoing banking crisis. Italy is a very different banking market from much of Europe, and its current crisis stems from different causes to that which devastated the sector elsewhere in 2009 onwards.
Italy's problem is not sub-prime or consumer debt, but the slow suffocation of its vital SME sector, which has been held back by euro membership and the lack of substantial labour market reforms. Italian competitiveness has suffered within the common currency as real wages rose despite high levels of unemployment. Unable to devalue within the euro, growth has accordingly been anaemic for decades. This has now led to corporate debt defaults which threaten to overwhelm the capital base of some of the second-line banks.
There is currently huge tension between Italy and the European Union (EU) over the proposed banking rescue. Under new EU banking resolution directives, a bank rescue by the state these days requires bond holders, and maybe depositors, to be bailed in too. This is not an enticing prospect for any politician aspiring to re-election.
With various Italian banks engaged in restructuring currently, could a fall of the Renzi government create a further banking crisis that could ultimately infect the whole of the EU banking system? A power vacuum certainly would not help the situation, as the Italian banking sector is in parts a mess that requires firm government action, and considerable clout in Brussels to bring to a successful conclusion.
A solution sometimes mooted is that the Italian government could inject around €40bn (£34.3bn) into the sector's capital base. That, however, would very probably be blocked by Europe, and is also a not inconsiderable sum for the heavily-indebted Italian state to find.
More likely is that, as now, a piecemeal solution is found to each individual situation, involving some quasi-state aid, some asset disposals, some mergers, some capital raises and some limited bondholder participation. In the current mood of euro-scepticism, Europe can ill-afford Italy to endure a further unnecessary crisis, although it has to be said that Jean-Claude Juncker appears to be rather hard of learning.
As for the Italian crisis metastasising into a full-blown resurgence of a European banking crisis, that is very unlikely. Elsewhere, capital ratios have been rebuilt and the ECB and other central banks are very alive to the need to keep finance available in a crisis through LTRO programmes and other liquidity lines. In 2009, the Baltics were supposedly going to bring down the Nordic banks and destroy Europe's banking system - it did not happen, and Nordic banks are currently reclining comfortably on deep cushions of capital.
Assessing the market's outlook from here is difficult, given the potential range of political contingencies, multiplied by the uncertainty of the market's reactions to those outcomes. Looking at where Italy is trading today, however, the level of short interest and the surge of interest in the referendum outcomes, one wonders whether much may already be in the price.
A ‘No' vote is expected on Sunday, with the result expected to be announced on Monday before market open. Either way, it promises to be a lively day on the markets, but at least some of the uncertainty should be removed, and markets can look forward to the next crisis.
Olly Russ is head of European income at Liontrust
The chairman isn’t answering his email
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Will report to Pat Shea