Italy's GDP advanced 0.3% in Q3, slightly beating 0.2% expectations and improving upon Q2's 0.0% reading. For those keeping abreast of the situation in Italy generally, the country is facing issues in the banking sector with large amounts of non-performing loans and experiencing ongoing anxiety regarding the UK's decision to leave the EU (the UK represents about 25% of the EU's economic activity) with respect to what it may mean for the greater region and its own interests economically. Most importantly, Italy's referendum on constitutional reform that is unlikely to pass. Current Prime Minister Matteo Renzi has all but staked his political future on the proposal.
Most polls show the "no" camp ahead by 5-7 points. In the event the "no" vote ultimately wins out upon the December 4 referendum - of which I'd assign at least an 80% chance as of this writing - Renzi is likely to resign. Given the rising discontent of establishment politics that has become a theme in elections and referendums throughout the developed world, a repudiation of the government's constitutional changes would be unsurprising. The outcome of a "no" vote would create economic uncertainty moving forward and could force an early election whereby the euro-skeptic protest party (Five Star Movement) could subsequently assume control of the Italian government.
Despite the seemingly sound intentions of Renzi's proposal to streamline and consolidate the structure of the Italian government, the country has fared poorly economically going back decades. The country is still reeling from a recession that lasted from Q3 2011 to Q2 2013, when measured on a quarterly scale, and from Q4 2011 to Q4 2013 (nine quarters total) when measured year-over-year.
Italy has not hit 3% annualized GDP growth in any given quarter since 2001. It has not grown by a 5% annualized rate in any quarter measured since 1980.
Over the past twenty years, the Italian economy has averaged less than a 0.5% annual growth rate. If we consider to 2% annual growth to be merely "treading water," the Italian economy is 37% smaller than it should be even under run-of-the-mill performance.
The country's unemployment rate stands at 11.7%, and has been below 8% for just five of the past 30 years. It broke below 6% for only a very brief period (one quarterly data point) in 2007.
The most distressing element of the Italian economy may be its inability to employ new workers. Youth unemployment (ages 15-24) peaked at 44% in 2014, but still remains highly elevated at nearly 40% currently.
The discontent among the country's youth is all the more likely to create a highly mobilized bloc of "no" voters. Added into consideration, this 40% figure fails to take into account underemployed and discouraged workers, as unemployment readings naturally take a very narrow definition of who should count into the reading, as they are inherently designed in such a way to reflect positively upon politicians.
Consequently, pollsters projecting the "no" camp to win out in two weeks are likely accurately observing the general sentiment of voters in the country. Given we're fully within the window by which the referendum is on investors' radar, global bond and equity markets are unlikely to see much upside in the intervening period.
Renzi's administration is banking on the hope that constitutional reform will lay the foundation by which structural reform and fiscal stimulus spending can work to find a solution to the country's perpetually stagnant economy. The country's primary task is to address the necessity of restructuring the Italian banking sector.
However, despite the intention of the reform to consolidate power in the Italian government to avoid gridlock and inefficient and ultimately ineffective governance, voters may look to vote "no" to the referendum as a way to block the ensuing power advantage it could provide to the ruling party. The reform would reduce the size and authority of the Senate and provide a voting majority to the party that wins national elections in the lower house. On top of that, matters of infrastructure spending would largely be transferred from local and regional governments to central governments. While this would bring greater stability to the central government and ensure that gridlock is avoided, most voters are against the autocratic overtones of a greater concentration of power within the central government. Accordingly, essentially every poll is showing that the nation is ready to vote "no."
In recent economic history, Italy has largely shared many of the same risk and general economic characteristics as Spain. Accordingly, the spread between each tranche of government-issued bonds has traditionally been very narrow, basically following in lockstep. However, since January 2016 Italy's bank situation has become increasingly public and since September the divergence between the two has grown noticeably. Currently the Italian 10-year trades at 2.10% versus 1.60% for the Spanish equivalent, a gap that hasn't been observed since 2012.
Despite polling errors where most pollsters missed the ultimate result of the Brexit vote, at its current trajectory, the Italian vote is unlikely to be a similar surprise.
Effects on Financial Markets
A delayed restructuring of the Italian banking sector is likely to be the most tangible result of the reform's potential upcoming rejection. Most investors in the Italian financial sector - and the European banking sector generally - would largely view a passage of the reform favorably. The reform's ambition of stabilizing the political climate and bettering the country's growth prospects would be viewed as a positive development. Over the past year, the largest Italian bank by assets - UniCredit SpA (OTC:UNCFY) - has worked to increase its capital ratios, but hasn't assuaged the concerns of investors. The bank's stock has declined approximately 65% within the past year.
Italy's (NYSEARCA:EWI) country-dedicated ETF has been down 24.0% year-to-date.
Expect the US-based equities markets (NYSEARCA:SPY)(NASDAQ:QQQ)(NYSEARCA:DIA) to remain relatively steady over the next couple weeks, as they take a breather next week for what's essentially an extended holiday weekend and the week after in anticipation of the result of the Italian vote the following weekend. Italian financial sector debt is expected to build in higher risk premiums as the vote approaches in anticipation of a "no" outcome. Italian sovereign debt is also expected to see its yields rise.
If, for any reason, the "no" result does not occur, such as a reversal in voter sentiment or the polls are simply very off the mark - neither of which is likely to occur - expect Italian debt, the euro, and European-based stock and bond markets (especially in financials) to rally accordingly.
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