In Scope:

Italy votes no

December 5, 2016
 
 
  • The Italian referendum is a political issue. The 'No' vote does not mean that Italy will now face an economic crisis or leave the euro area. European banks are better capitalised, there is stronger centralised supervision by the ECB, it is supplying bountiful credit and countries/banks have become less dependent on interbank ties, thus reducing the risk of an acute financial crisis.

  • The financial markets' initial reaction is therefore limited.

  • Although there are undoubtedly challenges ahead, we do not see the need to alter our investment strategy and are adhering to our cautious, positive economic outlook.

  • We support our recent decision to increase shares substantially but are also waiting for attractive buy-in opportunities. Bonds are still well below the benchmark level in a world where inflation is starting to creep up and the US Fed is on the cusp of increasing interest rates.

 

Some background information

  • Sunday 4 December was another important date on a packed political calendar. Italy took the pols to vote on a referendum on constitutional reform to curb the power of the senate and make the government stronger and more stable.

  • Although it is mainly an internal political issue, Prime Minister Renzi tied his political fate to the outcome.

  • The vote was overwhelmingly clear! As expected, the ‘No’ vote won a resounding and convincing victory. Almost 60% voted against the reforms.

  • This means a clear loss of face for Prime Minister Renzi, who announced he would hand in his resignation. Italy's president may ask him to stay on, appoint a party member to form a new government, or call early elections.

  • It has caused a great deal of uncertainty and yet another political crisis in Italy, but the roots of the problem lie deeper. Nothing new under the Italian sun... All the old problems remain: the economy is hardly growing and still at the same level it was in 2003. The sluggish bureaucracy and rigid labour market mean that companies lack competitiveness. The government debt ratio is the highest of the major euro area countries (133% of GDP). The banking landscape is fragmented and is grappling with bad loans and an inadequate capital base, witness the problems at Banco Monte dei Paschi.
 

What does this mean for Italian banks and the euro area's financial system?

  • Banks are much better capitalised this time round. Until 2008, it was quite common for banks to only have 4% of capital. Today, ‘ordinary’ banks must have a capital base of at least 8-10%, and systemic banks must set aside even larger buffers. As a result, European banks, including Italian ones, are much better able to withstand shocks than before. The close ties between governments and banks have also been largely cut.

  • The European central bank (ECB) has supervised the euro area's banking system since 2014. This means that controls are no longer carried out at the national, but at the euro-area level. This benefits objectivity and has also helped to identify banks with high levels of non-performing loans (NPLs) more quickly.

  • As regards liquidity streams: the interbanking market used to provide liquidity between banks (they borrowed from each other). When problems arose banks often refused to pay other banks because they were afraid of losing money. This is one of the factors that contributed to the 2008 banking crisis. Today, this interbanking market is less important because the ECB now provides individual banks with unlimited liquidities. The chance of a liquidity crisis is therefore limited and European banks have become less interwoven.
 

Market reaction and investment implications

  • The stock markets' reaction illustrates that they expected a 'No' vote and that they regard the issue mainly as an internal Italian problem:
    • The Italian stock market has risen but clearly lags behind the EURO STOXX 50®-index, the euro area's index comprising 50 of the euro area's leading listed companies, which rose 1.3% today.
    • The picture was very similar on the bond markets. Interest rates in the peripheral countries are going up while things are hardly moving in other countries in the euro area.
    • The euro came under pressure initially, but markets soon stabilised.

  • We are therefore not changing our investment strategy

  • Many forward-looking indicators still confirm that the health of the global economy is continuing to improve, despite the political uncertainty. What's more, after four very weak quarters, there are again (cautious) signs of a recovery in corporate earnings. We expect to see this trend continue in the quarters ahead and this warrants a positive stance.

  • Share markets remain fairly pricey, the political calendar in the euro area is very challenging and stock markets have digested unexpected scenarios such as Brexit, Trump, etc., very quickly. Nervous stock markets therefore cannot be ruled out, so we are keeping our equity allocation slightly under the benchmark weight and investing in defensive share themes such as high dividends, buybacks and family companies, supplemented with health care as defensive growth sector.

  • We also remain strongly underweight in bonds. How risk-free will bonds still be if inflation starts to pick up and interest rates are dragged along as a result?

  • We are also supplementing this with real estate funds and spreading our cash position over the euro and currencies offering higher interest and/or currencies that we expect to firm against the euro. We are also holding on to US dollars.
 
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