This Is What Analysts Are Saying About the Aftershocks of the Italian Referendum

A headwind for banking reform, growth and centrist politics, analysts say.

These Are Europe's Next Battlegrounds

Europe's political landscape just got more complex.

The Italian referendum defeat, and the subsequent resignation of Prime Minister Matteo Renzi, threatens to vex efforts to clean up the country's banking system and may set in motion prolonged political paralysis that would undermine structural reforms and the nation's battle against its heavy debt load. The resounding vote against the constitutional referendum that took the euro to a 20-month low before the currency rebounded may also embolden anti-establishment movements in Europe ahead of key elections.

That's the warning from market participants in light of the vote against government-sponsored constitutional reform that saw turnout higher than expected at around 70 percent and the 'no' camp garnering 60 percent of the vote.

Global stock markets and the Italy's sovereign debt market — the third-largest target market for the ECB’s bond-purchasing programme — largely took the referendum in their stride, but analysts warn of the potential for global turbulence ahead.

On the plus side for markets in the near-term: a technocratic government may be formed that would push through electoral reforms that could boost the representation of pro-euro, centrist parties, some analysts say.

Here's an overview of the reaction.

Analysts at Citigroup Inc. led by Giada Giani.

"The vote, coupled with the high turnout, is a resounding defeat for PM Renzi and another important victory for the anti-establishment/ anti-euro M5S [Five Star Movement] and Northern League parties, as the most prominent campaigners for No. While a clear rejection of the political status quo and of Renzi himself, EU and euro themes played a limited role in voter sentiment. Even so, the result is likely to boost support for both M5S and Northern League, which have vowed to hold a non-binding referendum on Italy's euro membership, increasing the political risk temperature for Italy over the medium term. Renzi’s defeat will be perceived as yet more evidence of Italy’s inability/unwillingness to push through reforms.

The government resignation does not imply immediate snap elections — it is quite common in Italian history to change government within the same parliamentary legislature. The ball now moves into the hands of the President of the Republic, Mattarella, who will launch party consultations in search for a new PM. Renzi’s ruling party PD retains the parliamentary majority and as such remains the kingmaker in the negotiations. However, the decisive referendum defeat suggests Renzi may not be able/willing to be re-elected PM. A super-party or technocratic personality may be chosen instead (the names of Upper House’s speaker [Pietro] Grasso or FinMin [Pier Carlo] Padoan have been mentioned by local media) over the next few weeks, probably supported by a broader parliamentary majority."

The analysts add:

"Developments on the banks will be the key focus in the next few days. A vicious spiral between higher government bond yields and weaker bank equity prices may spur a tightening in financial conditions and weigh further on GDP (although the downside risks on our already below-consensus GDP growth forecast of 0.5% for 2017 are probably not large)."

Deutsche Bank AG analysts led by Jim Reid.

"The trigger [for prolonged political instability] would be failure to form a new government due to unbridgeable divisions among traditional parties. A failure to find a compromise on a new electoral law could also have a similar impact but with a longer time horizon. All eyes would be on the banking sector in such a scenario and if a solution wasn’t found then stress could eclipse July 2016 levels.

[Our] central case is that a new government supported by a similar parliamentary majority to the current one, with a narrow objective – writing a new electoral law – and limited duration will be formed. This muddle through scenario means that Italy’s economy will continue to perform poorly in both absolute and relative terms and over the medium term there will have to been a convergence to either pro-reform government or a euro-sceptic government. So this is only the beginning of a long path ahead for Italy but expect swift political manoeuvrings this week as the country will need to try to find a solution quickly."

Daniele Antonucci, economist at Morgan Stanley.

"There's a limited risk of the Five Star Movement winning the next election, thus setting in motion a chain of events that may raise market perception of a possible euro exit. This is because the rules of the political game will change. Think about it: the polls saying that this protest party may win in the Chamber of Deputies are based on the current electoral law, which gives a strong majority premium to the winner. But negotiations are ongoing to amend this law and go back to a more proportional system. This will likely encourage and reward broad coalitions of mainstream parties, as the Five Star Movement is unlikely to join forces with someone else and 'dilute its brand'."

Economists at Barclays Bank Plc led by Fabio Fois.

"We think a “no” victory by such a large margin and the high turn-out are likely the worst outcomes from a market perspective for at least two reasons: 1) investors might initially interpret the outcome as a big “no” to Mr Renzi and in exchange a “yes” to anti-establishment forces; 2) the outcome could be seen as bad for long-term reform potential of Italy post the next general election. 

In addition, this outcome is likely to exacerbate concerns about the Italian banking sector and increase downgrade risks from rating agencies such as DBRS, although we do not expect rating agencies to act anytime soon, as they are likely to wait for political developments before taking any rating decision."

The economists add:

"Despite initial risk-off trading, we think the market’s attention will likely quickly move to the upcoming ECB meeting on Thursday. All else equal, the referendum outcome and likely poor price action in financial markets should reinforce a dovish QE extension and forward guidance from the ECB."

Francesco Garzarelli, strategist at Goldman Sachs Group Inc. 

Relative to our prior expectations, we would elevate our subjective probability from 45% to 60% of a caretaker government being appointed. We expect the Cabinet to be led by a political figure drawn from the ranks of the ruling coalition (one possibility is the Minister of the Economy, Mr Padoan). We do not see an outsider technocrat being appointed as this would be highly unpopular choice with the electorate. The new government would likely have a narrow policy agenda consisting mainly of: (i) Overseeing the recapitalisation of the partly state-owned Monte dei Paschi di Siena and potentially other smaller banks. If the referendum outcome stalls the current recap plans, a precautionary injection of public funds into these institutions could be required. In such a case, the application of the ‘bail-in’ rule book would be contentious, and the market instability exemption could be invoked; and (ii) re-drafting the electoral laws for the two Chambers of Parliament ahead of a general election in the spring of 2018."

Maria Paola Toschi, global market strategist at JP Morgan Asset Management.

"Bond market turbulence could have serious implications for the financial system. Most importantly, the Italian government would have to finance its huge debt burden at increased borrowing costs as a result of the effects of uncertainty on bond markets.

In addition, Italian bank balance sheets may suffer, given the overexposure of the country’s lenders to domestic sovereign bonds. The government collapse and the prolonged period of political uncertainty will also slow down or halt the rescue and recapitalization processes that are underway, as well as the bad bank programme, while foreign investors may be less willing to underwrite capital raisings of Italian lenders."

David Simner, fixed income portfolio manager at Fidelity International.

“Financials remain in the crosshairs, and investors will keep a close eye on the implications that the ‘No’ vote will have on the upcoming recapitalization exercises by Monte dei Paschi di Siena and Unicredit. We expect volatility ahead, until more details become available. However, it will be equities, rather than fixed income investors who will bear the burden of further rights issues on the horizon. We therefore remain comfortable with our positive view on Italian financials, particularly on the large national champions, who will continue to benefit from a stronger capital position, improved profit margins and a larger market share."

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