Italy's Prime Minister Matteo Renzi announced his resignation on December 5, the day after a referendum to reform the country's legislative process was rejected by voters. Renzi, who took office as prime minister in December 2013, had staked his political future on a "Yes" vote.
Dominoes Keep Falling
In one sense, the Italian referendum can be viewed as another victory for populism, which has been gaining strength across Europe. Euro-skepticism won its first major battle with Brexit in June, while global populist sentiment received a major shot in the arm from the election of Donald Trump in the U.S.
However, unlike both Brexit and the election of Trump, a "No" vote in Italy wasn't a major surprise to all. While undecideds ran close to 20%, the "No" vote was leading in most polls by about 2%–3% in the lead-up to decision day. As a result, the markets had a much more muted response. As the "No" vote became known on the evening of December 4th, major Asian equity indexes were down only fractionally while bond yields were down 3–5 basis points1 across Asia. In a mild flight-to-quality, the euro was off modestly while the U.S. dollar was up 0.6%.
It should be noted that even this muted reaction may only be partially the result of the Italian vote. The markets, particularly across Asia, may also be discounting the surprise resignation of New Zealand's prime minister John Key as well as heightened tensions around U.S./China relations following President-Elect Trump's phone conversation with Taiwan's President Tsai Ing-wen. This was a mild faux pas since the U.S. doesn't recognize Taiwan as sovereign under the "One China" doctrine2. Regardless of the specific attribution to the Italian vote, markets have gone mildly risk-off.3
More Cracks in the Foundation
The market response in light of these events has thus far been fairly muted. But what of the larger implications? While the structures supporting the EU and euro-zone system are not collapsing, the Italian referendum vote is another discernable crack in the foundation.
Italy's growth has been failing, its deficits growing, and the solvency of its banks is considered to be in question. The Italian banking system is laboring under massive non-performing loans (NPLs), which is hardly a recipe for reviving credit-driven growth. We believe Italy's fractious government holds little hope of addressing these problems anytime soon. Moreover, Renzi's fall opens the door further for other Euro-skeptic parties like Italy's Five Star Movement. Predicting European political paths is seemingly becoming a fool's game, but Renzi's defeat is another headwind to keeping "the European experiment"4 together.
Another Brick on the Load
While somewhat expected, the Italy vote and Renzi's resignation is moving markets at the margin. However, it does little to change, other than perhaps extend, many of our current views. We expect 2017 to be a year of increased volatility and dispersion. It would be naïve to think geopolitical risk has passed post-Brexit and the U.S. election. We believe it's just getting more interesting. The UK's withdrawal from the European Union under Article 50 may prove sloppy at best and downright painful at worst. While markets have reacted favorably towards Trump's growth agenda in the U.S., his dust-up with China over the Taiwan phone call is unlikely to be his last. Trump's political inexperience and ostentatious style may provide plenty of thrills and spills for global investors. Combined with elevated valuations across stocks globally, a Fed on the verge of hiking rates, and interest rate fears spreading across bond markets, it's difficult to forecast a reduction in asset volatility. After 7+ years of considerably solid returns across both stocks and bonds (post-Great Financial Crisis), we expect investor emotions to be tested more severely in 2017. The result of the Italian referendum is just another brick on the load that investors will have to bear.
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1 One basis point is equal to 1/100 of 1%.
2 The "One China" doctrine refers to the policy or view tha there is only one state called "China," despite the existence of two governments that claim to be China – the People's Republic of China and the Republic of China (also known as Taiwan).
3 The term "risk-off" refers to investors moving to supposedly lower-yielding investments which are perceived to have lower risk.
4 The term "European Experiment" is a broad reference to the European Union (EU). Dating to the Treaty of Rome (1958), the EU is a politico-economic union of 28 European countries that has an internal single market and a standardized system of laws.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Understanding current market conditions and what might be expected in the near term.
Understanding potential market trends in early 2017 requires a look at the market’s recent optimism.
During periods of market optimism, remaining mindful of risk is still important.