Lazard Insights. Italian Constitutional Referendum Basics for Investors. Summary. What Is the Purpose of Italy s Constitutional Referendum?

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1 Lazard Insights Italian Constitutional Referendum Basics for Investors Giuseppe Ricotta, CFA, FRM, Senior Vice President, Portfolio Analyst Summary We believe needs structural reforms to address the country s slow economic growth of the past fifteen years. s banks are under pressure as they have 2 billion in non-performing loans on their balance sheets. However, issues with these banks are not just economic, they are also political. Polls show most Italians do not fully understand the constitutional reforms and since Prime Minister Renzi pledged to resign if the vote fails, voters now see this as a referendum on Mr. Renzi. If the referendum fails, we expect some political and market instability in the near term. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via The Italian referendum on constitutional reform may be the next source of geopolitical risk in Europe. In this paper, we will review the merits of the reform, delineate various scenarios after the vote, and assess the reform s implications for investors. What Is the Purpose of s Constitutional Referendum? The objective of the constitutional referendum, which currently is scheduled on 4 December 216, is to reform the role of the upper house in the Italian Parliament (the Senate). Currently, the Senate and the Lower House have exactly the same powers. The reform would eliminate duplicate powers and transform the Senate to a consultative chamber of local government representatives. If the referendum is successful, the number of senators will decrease from 315 to 1 and the number of elected politicians in parliament will shrink from 945 (63 in the Lower House plus 315 in the Senate) to 73. Prime Minister Matteo Renzi has pledged to resign if the referendum fails. This quickly backfired as it became evident that the opposition started campaigning for the No just to get rid of him. When Mr. Renzi realized this and took a step back in August, the damage was already done. Importantly, the reform also introduces several new paths for a law to be approved and we believe the reform is a positive step for. First, it should make it easier and faster to pass new laws. Second, we believe the reform, coupled with the new electoral

2 2 law,¹ may help ensure government stability. This is important in a country that has had sixty-four governments since World War II. Finally, we believe reducing the number of elected officials in parliament is the right move, even if the actual cost reduction is small, given the exorbitant costs of the Italian political system. On the other hand, we believe the reform could have been better. We believe the majority premium in the new electoral law (the Exhibit 1 Economic Growth in Has Lagged the Euro Zone Real GDP, March 28= As of June 216 Source: Eurostat, Haver Analytics Euro Zone 216 so-called Italicum) is too high with 54% of the seats going to the party or coalition that wins 4% of the votes however, the government has recently said they will revise this if the referendum passes. Also, in our opinion the Senate could have been eliminated altogether if it is not going to have any real authority. The Importance of the Referendum s Economic Malaise We believe successful constitutional reform will pave the way for meaningful structural reforms over the years ahead. These reforms are critical to escaping the economic malaise that has yet to end for after the global financial crisis, in our view. s economic growth since the global financial crisis has lagged the euro zone (Exhibit 1). A key driver of this slow economic growth has been the abysmal growth in productivity and the unemployment rate is a manifestation of this economic malaise in (Exhibit 2). While unemployment has declined since it peaked after the euro zone sovereign debt crisis, it is still approximately 11.5%, which is 1.5 percentage points higher than the euro zone average. Importantly, there is an increased risk of poverty for s younger generation (Exhibit 3). Finally, as migrants continue to enter the country, an increasing number of younger Italians are leaving the country. Exhibit 2 Low Productivity Has Contributed to s Slow Economic Growth Real Labor Productivity per Hour Worked, 21 Average= Euro Zone Exhibit 3 s Younger Generation Feels Left Behind People at Risk of Poverty or Social Exclusion by Age, Share of Total Pop. (%) From 18 to 24 years Less than 18 years From 25 to 49 years Total From 5 to 64 years Unemployment Rate (%) (Persons, thousands) Immigration years or over 1 9 Euro Zone 2 1 Emigration Productivity data as of June 216, unemployment data as of August 216 Source: Eurostat, Haver Analytics As of 215 (poverty data updated 24 October 216 and immigration data updated 1 June 216) Source: Eurostat, Haver Analytics, Istituto Nazionale di Statistica

3 3 s Banking System Complicating the situation regarding the referendum is the anxiety over the fragility of the Italian banking system. Non-performing loans (NPLs) in the banking system have reached 2 billion this year and are distributed across a number of sectors (Exhibit 4). However, there are some early signs that this situation may improve. In fact, the government has passed a reform of bankruptcy proceedings, which over time should make it faster to repossess assets, thus increasing the value of the underlying collateral. Several banks, including some of s big banks, need recapitalization. However, new rules in the euro zone enforce a bail-in of creditors (where creditors forgo their short-term claims or agree to restructure these claims) before any government assistance can be provided. The problem is that many of these creditors are Italian retail investors and, from a political perspective, the government cannot afford to enforce a bail-in on them. In this context, the referendum is very important to ensure government stability, which is required to find a solution for the troubled banking sector. What Do Italians Think about the Proposed Constitutional Reform? Recent polls suggest that Italians have limited knowledge on the constitutional reform. Only 9% of respondents affirm to know the reform in detail. On the other hand, data suggest the majority of Italians plan on using the referendum as a vote for or against the government (Exhibit 5). Exhibit 4 Italian Banks Have 2 Billion in Non-Performing Loans NPLs by Borrower ( billions) NPLs by Sector Other Households Construction Other Sales Services Other Sectors Commercial Services Fishing and Agriculture NFCs 216 Textile Food, Beverages, and Tobacco Share of Total (%) Sector data as of February 216 and borrower data as of July 216 NPLs = non-performing loans. NFCs = non-financial corporations. Source: HSBC Exhibit 5 Most Voters Show Limited Knowledge on the Issue The Main Reason for Voting Approve/Reject Mr. Renzi s Government 53% Does Not Say 2% How Well Do You Know the Content of the Reform? In Detail 9% Broadly 42% I Don t 11% Approve/Reject the Specific Content of the Reform 27% I Have Heard about It 38% As of 15 July 216 Source: HSBC, Ipsos Poll

4 4 In the past, polls have proven to be unreliable in. However, recent polls on the referendum have provided an indication about how divided the electorate is. The issues we have highlighted (low growth, high unemployment, the continued flow of migrants into, and a weak banking system) have fueled rising antiestablishment and anti-euro sentiment in the country. In this context, populist parties like the Five Star Movement and the Northern League have reached a consensus and are campaigning for a No vote. Importantly, given this is a constitutional referendum, there is no required minimum turnout of eligible voters. Voter turnout will be key, in our view, as the percentage of undecided voters is still very high at approximately 25% (Exhibit 6) and those with strong opinions are more likely to vote (as we saw earlier this year with the Brexit referendum and with the US presidential election in November). Those in the Yes camp believe the current constitution was written for post-world War II. They believe these changes are needed to modernize the country and make it easier to enact further reforms in the future. In addition, a No vote is a vote for the status quo, which has proven to be ineffective over the years. Finally, those in the Yes camp argue that 73 (highly-paid) members of parliament are more than enough. In contrast, those in the No camp believe the reform will introduce too many new paths (twelve) for a law to be approved, while currently there are only three and that does not need to approve more laws faster, it needs better laws. In addition, the No camp argues that the cost reduction is much lower than what is advertised by the government and understands that a No vote will get rid of Prime Minister Renzi. Political Implications The Yes and No campaigns are currently running so the situation is fluid. At the date of writing, we assess the following scenarios and probabilities: Yes wins: 45% No wins and new caretaker government with Renzi as Prime Minister: 3% No wins and new technocratic government: 2% No wins and new elections: 5% Exhibit 6 Polls Provide an Indication of Voter Polarization Share of Respondents, Weekly Average (%) Jan 16 As of 17 October 216 Source: HSBC, Wikipedia Apr 16 Jul 16 Yes, Accept Reform No, Reject Reform Don t Know Oct 16 The importance of structural reforms must be stressed. The current political system has proven to be ineffective over the years. For instance, a law needs to be approved multiple times by both chambers; even if just a comma is added or removed, the process must start over. The referendum is also a key complement to the new electoral law for the Lower House, which is based on a majority premium of 54% of the seats assigned to the party reaching 4% at the first round or winning the second round (there is also a threshold for smaller parties to enter parliament equal to 3% of the votes). Importantly, cutting the number of elected politicians sends a signal that the government is starting to reduce the cost of its political apparatus by as much as 5 million according to the government which is one of the most expensive in the western world. To boost the popularity of the reform, Renzi said that these savings will be spent on a new poverty fund. We believe that political stability is important to continue the reform process to address the economic malaise and fix the banking system. At the same time, regular elections are scheduled in May of 218, so even if Yes wins there could be a change in government in the not-too-distant future. In addition, there is general agreement across the political spectrum that needs reforms. Over the medium term, we expect reforms will eventually be implemented, no matter who is in charge. Importantly, is the only major country in the euro zone that does not have a credible, pro-european alternative to the current government, which could exacerbate political instability. A potential political crisis could open the door to populists.

5 5 Investment Implications was the best-performing equity market among the largest euro zone countries in 215, but has significantly lagged in 216 (Exhibit 7). Stalling economic growth (particularly in the second quarter), banking system issues, and the political risks posed by the referendum have all contributed to this weak performance. The key question for investors is if these risks are already fully priced in the market. We believe these risks are only partially priced in. Fixed income markets have also priced in these increased risks in, as the spread between s 1-year government bond and Spain s 1-year government bond has turned positive for the first time since March of 215 (Exhibit 8). Conclusion While s constitutional referendum may bring about muchneeded change, most Italians do not know the details of the reform and will instead use the vote to decide whether or not they want Mr. Renzi to remain as prime minister. If the No camp wins the referendum, we expect some political and market instability. However, we believe is in dire need of reform and it will eventually get done, with or without Prime Minister Renzi. Exhibit 7 s Equity Market Has Significantly Underperformed in 216 Returns (%) France Germany Spain 216 YTD As of 3 September 216 All data in USD based on total return (net) MSCI country indices. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposely only and does not represent the performance of any product or strategy managed by Lazard. Source: Haver Analytics, MSCI Exhibit 8 The Spread between Italian and Spanish Bonds Has Been a Proxy for Referendum Risk 1-Year Government Bond Yield Spread (bps) Jan 15 Jun 15 Nov 15 Apr 16 Sep 16 As of 25 October 216 Source: Haver Analytics, Reuters

6 6 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 The Italian electoral law of 215 enacted a two-round election system based on party-list proportional representation, which is corrected by a majority premium and a 3% election threshold. Important Information Published on 7 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 16 November 216. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit for the specific Lazard entities that have issued this document and the scope of their authorized activities. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. RD199