Investing In The Italian Referendum

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Summary

The Italian Referendum on December 4th has received little attention while being of consequence.

Uncertainty surrounds the vote: both "Yes" and "No" can be viewed as not-positive.

Everyone has been too busy with Trump and now the event is a week away: markets will move.

Italy is off-limits for investors this week, depending on the outcome maybe longer-term even.

I would like to bring something to the attention that has not yet received many contributions on SA. I do believe that you will hear a great deal about it this week. Some media-outlets consider it a risk on par with Brexit.

Italy will have a referendum on the 4th of December. I will not try to make too much of a case for why this is, mainly because my interests lay elsewhere. Lets start with some media commentary on the event:

WSJ:

If rejected, a Dec. 4 referendum in Italy has the potential to send the country's bank shares tumbling, push bond yields up and further weaken the euro.

CNBC:

Italian referendum a bigger risk than Donald Trump, analysts warn.

Independent:

This matters massively, not so much for the specific issue, to approve constitutional changes, but rather because it is a vote of confidence in the government. Given the difficulties of the Italian economy of near-zero growth over the past 15 years and the weakness of the banking system, this could trigger a strong adverse reaction if the vote turns out to be No.

Background

Italy is going to have a referendum on constitutional reform. Referenda are all the rage these days. Their track record of ending well for establishments has not been that great in the very recent past. What it boils down to is that Italy's PM Renzi semi-promised to leave office if the vote turns out to be a "No" (nothing changes to the constitution). This might lead to early elections, which might lead to a Roman rerun of the Trump spectacle. The 'Five Star Movement' is currently leading in the polls and as you might have guessed from its name this is not a cozy right-wing party. First act of business if these guys come to power: hold a referendum on the EU membership. So, the potential for the end of the Euro (to state it a bit dramatic) is enclosed in the 4 December referendum. In case of a "Yes" it's not all 'Hail Mary' either. Apparently the measures proposed make it very easy for government to truly rule, i.e. it will be easier to pass laws and the power of the senate is strongly cut back. This in turn could lead to issues down the road when the extreme-right party wins the election. Latest polls indicate that "No" will win by a small majority.

It's clear there is something on the line for the European Union and policymakers will be watching the event closely. For financial markets it is hard to say what will happen. Italian bonds clearly shouldn't fare well with this kind of event. The 10-year bond yield is currently around .5% higher than the Spanish 10-year bond yield and the highest since the beginning of 2012. The gap between the Italian and German 10-year yields has also widened recently. We are going to be looking at equity however.

Opportunity

The past two months (and still) all eyes were focused on the US presidential election and what the aftermath meant for markets. Safe to say that at this point almost everybody will have heard the phrase 'Trumponomics' more than enough. The Italian referendum is coming into view now and this is well late for this type of event. It will be held next Sunday. Somewhere this week a lot of people / funds with exposure to Italy will ask themselves if they want to ride this one out. My guess is many will not bother with the specifics of this one and just get their money out and see what markets will do the beginning of the week after December 4th. Usually these choices are made well in advance, but this one is coming a bit more as a surprise. Trump is of course a major contributor to this. To see why I think there has not been much response yet we can look at the Italian MIB index for the last month and compare it to other indices (see below).

Click to enlarge

Source: Google Finance

On the chart we see the outperformance of the S&P after the Trump victory clearly (green line). The MIB (red line) underperformed the DAX and Eurostoxx indices only slightly; about 1 percent compared the Eurostoxx at last Friday's close. This doesn't seem like there is major selling pressure on the Italian index to me. But when we look at specific stocks we can already see the sell-off in Italian banks has begun (see chart below).

Click to enlarge

Source: Google Finance

The chart clearly shows the larger Italian banks underperforming the Stoxx European banks index. The index is up more than 6% over a period of little more than a month, however it is roughly flat since Trump's victory. That is a huge difference when compared to the US banks. Here we might be seeing the first equity signs of the Italian Referendum being priced in.

The sell-off in the banks is poorly reflected in the underperformance of the MIB vs other major indices, although the MIB is relatively bank-heavy. Meaning the non-banking shares in the Italian benchmark have performed relatively well. This is exactly what you should be hoping for in terms of opportunity. There are clear sell-offs in the directly affected risky assets (bonds and bank stocks) but the index hasn't moved that much yet. But it will. Why? Back to my previous point: managers didn't see this one coming so clearly. They typically hold larger indices or larger markets, e.g. Europe. While the smart money has already sold the stuff that will get hit, these guys are going to be confronted with the choice I described above. They don't want to hold Italy over this event, period. They will start selling the whole index, if only to get rid of the banks that are in there. This delayed move will come this week.

Trade and Risk

From the above it will be clear that my trade recommendation is to sell Italian exposure if you have any. Even if you want to keep being long Italy, it will probably be a cheaper buy next week. A more active way of trading the opportunity is selling the MIB index or the iShares MSCI Italy Capped ETF (NYSEARCA:EWI). Hedging would be recommended with this type of play, since it's hard to predict the market move, especially where the market is now. go long 1) a European euro country such as Germany via the DAX or the iShares MSCI Germany ETF (NYSEARCA:EWG) or 2) buy U.S. ETFs

A European long position will of course correlate better with the Italian Index. A U.S. index is a great long position if you expect the market to move down (as we do here), especially given the performance of the last weeks, plus the correlation with Europe is not bad either. Total position I would recommend making value-wise flat, but you can play around with this a bit. I'm 50/50 U.S. and Germany long against Italy. Risk is fairly limited in this spread. Markets moving up hard could pose a threat, but I don't see that happening at this point in time, especially given the move we have already seen the past three weeks. Even then Italy has a good chance of underperforming the other indices given what is in store next Sunday.

Conclusion

Italy is off-limits this week for investors. If there is a "No" vote this Sunday then the Italian market is going down, quite possibly for longer. Italian banks will become a very big question mark for the foreseeable future so investors should be cautious of stepping in. The "Yes" vote winning doesn't lead to the conclusion that Italy is a buy for the long term either, however you can expect the market to move up steeply the Monday after the vote.

Disclosure: I am/we are short MIB / LONG S&P AND DAX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.