Markets Moving On From Brexit & Trump
Following Brexit and the US election, the next key political event for markets to focus on is the upcoming Italian constitutional reform referendum on December 4th. Looking at the performance of the Italian government bond and equity markets recently, it seems that the impact of a “no” vote is already somewhat priced in. However, looking at the implied moves in options suggests that the equity market is pricing in only a limited probability of extreme moves indicating a lack of concern over contagion risk.
In terms of analysing risk relating to the referendum, it’s important to consider both short-term and medium-term downside risks and also both short term and medium term upside risk.
Short-Term Downside Risks
In terms of short-term downside risk, the key factor to monitor will be the banking sector. In the case of a “No”, it is likely that PM Renzi will resign and then the market will have to deal with the risk of a Government vacuum. A negative market reaction could put severe stress on the Italian banking sector which, if a solution is not found quickly, could move beyond the stress levels seen in July 2016.
Medium Term Downside Risks
The medium-term downside risk then is more aligned to the status of the Italian government in the wake of the constitution reform referendum. There is a risk that a new and extended period of ineffective government leads to systemic instability in the medium term. A scenario where the government simply muddles through will likely see no significant reforms made which would likely lead to the Italian economy performing poorly in both absolute and relative terms.
This would clearly be unsustainable, and hence, over the medium term, there is an elevated risk of convergence to either a pro-reform or Eurosceptic government. The concern here is that the longer Italy spends simply trying to “muddle through”, the higher the support for eurosceptic parties will continue to grow. Current polling shows that Italy’s three euro-sceptic parties already capture a cumulative +40% of the potential vote.
Short Term Upside Risks
The short term upside risk is that In the case of a “Yes” vote there is room for a significant rebound in Italian assets driven by banking sector stocks, as market expectations appear to be tilted in favour of a “No” vote. According to the latest polling results conducted ahead of a two-week blackout period leading up to Dec 4th, there was still a large proportion of voters who were undecided. A large amount of undecided voters creates a great deal of uncertainty heading into the referendum.
Polls have come under increasing scrutiny following the outcomes of both the UK’s EU membership referendum and the US elections where in both instances the results of the majority of polls were caught offside by the outcome of both events.
Medium Term Upside Risks
Finally, the medium term upside risk is linked to the emergence of an unlikely systemic solution. It seems unlikely that there would be any immediate proactive systemic solution for the banking sector even in the event of the Senate reform being approved. However, if a systemic solution for the banking was agreed this could be a chance to dismantle the current negative feedback loop of growth-banks-politics and revitalise the reform process. A systemic solution being implemented would lead to an upward revision to GDP forecasts.
Ahead of the referendum the Euro continues to be under pressure remaining in the very lower bound of the two-year range that has framed price action since January 2015. Having broken below the rising trend line from last year lows, bearish pressure remains intact, and traders will be looking for a break below the 1.0460s lows to confirm fresh downside.