In a constitutional reform referendum on 4 December, Italian voters will weigh in on some key proposals, chief among them the abolition of the Senate’s legislative power. This would leave the lower house (Chamber of Deputies) as the key legislative body, a move proponents say will streamline Italy’s political system, clear a path for needed reforms and ensure a clear winner in the next general election.
Prime Minister Matteo Renzi’s pledge to resign if the reform fails has made the vote highly politicized, and the attendant political uncertainty has fueled nerves among market participants. Polls suggest the vote is too close to call (see chart), and the high proportion of undecideds (around 30%) compounds the uncertainty.
While we believe a failure of the referendum to pass would hurt the country’s long-term political stability and reform prospects, we view the key risk to markets to be the election of an anti-establishment euroskeptic government – an outcome we think is unlikely irrespective of the referendum’s outcome (with a “no” arguably making the possibility even more remote). In brief, we envision the following scenarios:
- A “yes” vote: Better for the markets. Italy would adopt an electoral system that delivers a clear winner, and Renzi would likely stay in power until the legislative term ends in 2018. At that point, it may become a close contest between Renzi and Beppe Grillo’s anti-establishment Five Star Movement (M5S).
- A “no” vote: Politics as usual. Renzi would likely resign, but we would not expect new elections to be called (this because the Senate would retain legislative power and be elected with a proportional electoral system, which would probably deliver a hung parliament). President Sergio Mattarella would thus likely push for the formation of a transitional government – perhaps led by Renzi himself – tasked with implementing a new electoral law before proceeding to new elections. This scenario would feel like an old-style, “muddle through” political development for Italy, and would also hurt Grillo’s chances to win an election outright.
Longer-term caution, short-term opportunity
We are cautious when investing in European assets over the medium term. Our secular investment focus on capital preservation is especially relevant for the region, where the macro outlook is underwhelming, political risk is elevated and compensation for that risk is slim.
In the near term, however, volatility in peripheral spreads and European risk assets could rise in the run-up to the referendum, and risk would likely underperform in the aftermath of a “no” vote. This could create opportunities to add risk at more attractive levels, especially in peripheral sovereigns, which remain anchored by the European Central Bank’s quantitative easing. We would be more cautious about Italian bank exposures, where vulnerabilities persist and where a “no” vote could further increase execution risk for banks’ ongoing recapitalization plans.
Nicola Mai is a PIMCO portfolio manager and leads sovereign credit research in Europe.