Another One Bites the Dust

Transcription

1 DEC Another One Bites the Dust J. Patrick Bradley» Italy Ties Its Future to Ill-Fated Vote First there was Brexit, creating a blowback in the financial and currency markets. British Prime Minister David Cameron resigned, as promised, following the U.K. populace's decision to exit the European Union (EU). Next, as Donald Trump defied expectations and convention to become the forty-fifth president-elect of the United States, the wave of populism continued to break. Then came the Italian referendum vote on December 4, Once again, a prime minister in Europe tied his fate to an outcome over which he had no control. Italian voters soundly rejected Prime Minister Matteo Renzi's efforts to reform the Italian constitution, mainly by reducing the power of the Italian senate. Renzi resigned, but will continue to lead the Democratic Party (Partito Democratico) and will likely stand as his party's candidate for prime minister in the next election. Clearly, Italy still has much work to do. However, the Renzi referendum defeat should not be interpreted solely as a populist, anti-eu backlash that will spread across the eurozone, through France, the Netherlands, and Germany all of which have scheduled elections in Opponents of the referendum included not only populist and regionalist parties, such as the Five Star Movement (5SM) and the Northern League (NL), but also many mainstream voices, like former premier Mario Monti. Interest rate spreads and Italian sovereign credit default swaps (CDS) appeared priced for the rejection vote.

2 Referendum Implications Must Be Addressed, Quickly 1. The focus will be on stability. A caretaker government will be formed, with the elections possibly taking place as scheduled in The earliest those elections can occur is 45 days after the parliament is dissolved, which would likely be around June President Sergio Mattarella has charged Paolo Gentiloni, once the minister of Foreign Affairs, with forming that caretaker government and obtaining the approval, in the form of a vote of confidence, from the Italian parliament. Renzi had been offered the position, but turned the president down. Bank stocks rebounded on the Gentiloni news. 2. Gentiloni has a short "to-do" list. Italy's president has indicated that elections will not be moved forward unless the electoral law that awards a "bonus" to a political party receiving 40% of the vote is changed, colloquially known as the Italicum. The law covers only the Chamber of Deputies, the lower house, and poses a risk that the anti-eu elements could win an election under the current Italicum. The Constitutional Court will review this law on January 24, Not surprisingly, the leftist M5S and rightist NL have demanded a snap election. Opinion polls currently indicate that the Democratic Party (PD) and M5S are generating the same percentage of support, roughly 30% each. The second to-do item is to address the Italian banking sector, a sector plagued by a high non-performing loans. 3. Banking must be addressed. Monte dei Paschi di Siena (MPS), the third largest bank in Italy, stands as the face of the banking dilemma in Italy. The bank has been trying to fill a gaping capital hole uncovered earlier by the eurozone bank stress tests. Currently, it is attempting to raise EUR5 billion privately by the end of the year, a deadline that the European Central Bank (ECB) declined to extend, which caused a sharp selloff in Italian bank stocks. The bank is working with underwriters JPMorgan and Mediobanca to raise the necessary cash infusion. A debt-to-equity swap has been proposed that includes roughly 40,000 largely retail investors, and the bank plans to sell EUR27 billion of its worst loans. In addition, the Qatar sovereign wealth fund is being looked at to provide EUR1 billion to the bank. The uncertainty created by the referendum outcome could cause private investors to walk away. That development would likely lead to the Italian government stepping in to provide support. However, under EU banking rules investors would have to bear some of the burden of the state's intervention efforts. Retail investors have a sizeable exposure to the banking sector's bonds. Any bail-in, or burden sharing, could seriously hit consumer confidence and consumer spending. Without a healthy banking system, the effect of the ECB's monetary policy will be largely ineffective in generating economic growth in Italy.

3 4. The Italian economy needs kick-starting. Italy's economy has been a disappointing performer among the eurozone economies. It grew a mere 1% during the third quarter and will grow less than 1% for Italy has been a laggard in instituting structural reforms that would overhaul its economy, making it more efficient and competitive. Renzi focused on reforming the institutions of government, allowing the government then to pursue the much needed reforms. The "no" vote puts these reforms in limbo. Labor reforms in Italy have been modest compared to other peripheral European countries. Since 2005, Italian productivity has actually declined, with unit labor costs up 4%, compared to Spain's fall in labor costs. Italians hold Renzi's efforts to create a more efficient economy responsible for sluggish growth, high unemployment, and relatively tight fiscal policy.

4 Conclusions Many analysts are tempted to blame the wave of populism for the defeat of Italy's recent vote on constitutional reforms. However, the world did not end when the Italian people voted down the Renzi-inspired referendum, nor did it necessarily signal the beginning of a swelling populist tide that threatens to overtake the rest of Europe. The lack of support for the referendum was not limited to the populist movement. Instead, it appears to be driven by more broad-based disappointment with the overall performance of the economy and Renzi's responsibility for the lackluster growth. Analysts now worry whether Italy will leave the eurozone, an outcome that appears unlikely. Italy stands at an important crossroads and faces a number of economic challenges. Credit rating agencies Fitch and DBRS both have a negative outlook for the Italian economy, a factor that could raise the government's financing costs. Paolo Gentiloni, Italy's new prime minister, needs to restore confidence in a country that has had 63 governments since the end of World War II, a herculean task. Financial markets appear to have adopted a wait-and-see posture. Italian sovereign yields are largely unchanged, with the central bank purchases of Italian bonds potentially dampening any rise. Italy's equity market has experienced a sharp advance since the end of November and has held those gains. Bank stocks too have moved higher. While Italy's next move is uncertain, what is clear is that it will come from the Gentiloni-led caretaker government. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

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