The referendum in Italy on constitutional reform on December 4 th is likely to be the main source of concerns for the financial markets during the next few weeks.
With the "NO" camp slightly ahead in the polls, investors fear that a period of political instability could follow as the head of the Italian Government Matteo Renzi could resign, leading to a caretaker government and new elections in the spring.
The ten-year Italian government bond yield surged from 1% in August to a maximum of 2.17% during the last week. It is an increase higher than the one recorded by other developed markets. Despite remaining at historically low levels, the high level of the spread with the German 10 year government bond yield, 182 basis points, and with the Spanish government bond yield, 50 basis points is a strong sign of stress on the market. The spread between Italian and Spanish 10 year government bond yield has been higher only during the 2011crisis, when it reached 200 basis points.
In our view, the tensions between the Italian government and the European Commission on the latest Italian budget law are also having a negative impact on the Italian government bond market. According to European commission the law does not respect European parameters.
We think that the increase of Italian government bond yields could have a negative impact on public finance. Indeed, falling interest rate payments had a significant role in the decline of the Deficit/GDP ratio from 3% in 2014 to 2.3% in 2016. Interest rate payment decreased from 4.6% of GDP in 2014 to 4% in 2016 albeit the public debt remained basically unchanged at 132.5% of GDP.
An increase of government bond yields could make more difficult for Italy to achieve the reduction of public debt agreed with the European Commission. Indeed it could force the Italian government to tighten fiscal policy to reduce the deficit/GDP ratio, with a negative impact on economic growth. It would be a re-proposal of the vicious circle already seen in the Euro zone during the last few years.
In this scenario, the fragile recovery of the Italian economy will be at risk despite the encouraging signs come from GDP data: Q3 GDP grew by 0.3% q/q, above consensus estimates at +0.2% q/q. The latest business confidence indices signaled that the recovery could continue in late 2016/early 2017. According to Bloomberg consensus estimates, GDP could grow by 0.8% both in 2016 and in 2017.
A tightening of fiscal policy that lower GDP growth and eventually put the economy into a recession could have hard-to-predict consequence on the European Union, which is already suffering from Brexit.
We think that rising interest rate could have a negative impact also on the Italian equity market. Since 1993, the Italian equity market (NYSEARCA: EWI) has recorded a monthly average gain of 0.8% when the Italian government at the end of the previous month was lower than the value of the year before. Otherwise it has lost a monthly average of 0.5%. The current government bond yield suggests to not investing on the Italian equity market, in line with the indications coming from the main trend indicators.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.