We need to talk about Italy …

Year to date, the main Italian index, FTSEMIB, is down more than 20% (Price return, €) and has underperformed the broader European market by c22%. This has been driven by concerns surrounding the high levels of Italian gross non-performing loans (NPLs) in the banking system and the pending Italian Referendum

The latter takes on particular significance as it precedes the raising of capital in the banking sector and unlike the pre-Brexit case, the market has decided to position cautiously.

The Italian referendum isn’t merely impacting Italy. Concern about the Italian referendum is also contributing negatively to European equity asset allocation more broadly, with investors globally, from Lima to Taipei, citing it as a major concern. Figure 1 below shows the last 6 years of US fund flows into European equities. It is clear 2016 is an anomaly especially when you consider over the past 6 years international investors have had to absorb the Banking crisis, sovereign crisis, Greek crisis…etc.

Given the Italian referendum has seemingly become “the” near-term issue, we thought it would be useful to lay out the key facts leading up to the vote on December 4th.

The Question

The Italian referendum is entirely different to the UK’s Brexit vote. Italian constitutional law (Article 75) doesn’t allow a binding referendum on international treaties which includes, for example, European membership. We can dismiss this misunderstanding immediately.

It’s also worth highlighting that Italian referenda are not unusual: there have been dozens since 1948, and this is the third important constitutional referendum since 2001.

The December 2016 referendum question is:

“Do you approve the modification of current Bicameral system into a Unicameral system, the reduction in number of MPs, the reduction of the costs of the institutions, the cancellation of CNEL (“Consiglio Nazionale Economia e Lavoro”) and the modification in Chapter V of Constitution?”

To simplify, this question is asking the Italian people whether they want to speed-up the domestic legislative process and reduce the cost of government. In more detail, the question is asking the electorate to reduce the power of the upper Senate in law making and reduce the number of senators from 315 to 95. It also asks to return more power to central government from regional level. All this reform is designed to simplify law making and improve Italy’s capacity to reform.

Why has the Italian referendum become an issue then?

Because Renzi has made the vote about him. Matteo Renzi, the Italian PM is unelected; his position as PM is a function of winning leadership of the Partito Democratico (PD) 8 months after the General Election. Buoyed by his initial popularity, he promised to resign IF the pending referendum result was a No. However, in the subsequent months the PD party has lost political ground to the populist Movimento 5 Stelle (5 Star Movement) as the electorate has become disillusioned at slow reform progress. Last polls suggest 5*M 30.3%, PD 29.3%, Forza Italia (Berlusconi) 12.3% and Northern League (12.1%). Seeking to make political capital out of Renzi’s fading popularity, 5*M and the Northern League are calling for a NO vote. Forza Italia are also leaning towards a No.

All this means the referendum result doesn’t matter hugely in its own right making it entirely different to the UK. Whilst a no vote will hamper Italy’s ability to reform, the real risk is it could lead to political turmoil.

It appears Renzi is aware of his mistake of personalising the vote, and in recent days he appears to be back-pedalling on the promise. His ability to stay will depend on how big the turnout is (small and he’ll claim it lacks legitimacy) and how much he loses the vote by.

Even in the “worst case” scenario where Renzi is forced to resign, then it’s far from automatic that we get a change in government. It wouldn’t automatically trigger a General Election. Assuming Renzi’s resignation was accepted by the President of the Republic (not certain), then the PD will appoint a new leader and it’s most likely the Italian President will ask the new leader to form a new government and hence maintain the Italian status quo.

As an aside, some more cynical political commentators flag few members of parliament want a general election for selfish reasons: The current parliamentary mandate has just 18 months to run and MPs who serve a complete term get very generous pensions for life…

So in an adverse scenario, Italy loses their reformist PM and that’s not good…for Italy. It means more of the same, with impotent government. It doesn’t mean contagion risk to the rest of Europe.

Italians should vote for change…except for politics

Currently the leading political party, the populist 5 Star Movement’s founding principle was for change. They gained notoriety from their charismatic leader (Beppe Grillo) rebelling against fat, wealthy and corrupt government with a promise to change the way Italian politics operates. Despite the referendum being aligned with those founding principles Grillo is advocating voting no, specifically to get Renzi removed. How important Grillo is remains to be seen: Since winning leadership Rome and Turin in the summer the 5 Star Movement has already been accused of both incompetence and corruption, therefore seeing their popularity decline.

Current polls have the “No” vote ahead, but c40% of those polled are still undecided. As already mentioned referenda are commonplace in Italy typically with low voter engagement and turnout. Being a constitutional referendum, engagement should be higher, but only as the date approaches. “It’s still summer in Italy, December 4th is a winter problem” a local recently told us. Perhaps telling, the much loved Italian Oscar winner, Roberto Benigni, is one of very few celebrities to openly comment on the referendum. Despite being opposed to Renzi personally, he’s quoted as saying “If the No wins it will be worse than the Brexit. It is essential to win the Yes. You have to think about the good of the Italians”. His point was clear – vote Yes, not to support Renzi but because Italy needs reform. Given Italian growth is amongst the lowest in Europe and there has been a lack of real reform since the financial crisis it is illogical for the public to vote No, he implied.

Forza Italia’s stance is interesting. So far they are loosely backing No, which is relevant because Berlusconi controls Italy’s biggest TV station, Mediaset. Berlusconi is 80 and slowly recovering from a recent operation. He is not the political threat he once was and therefore his party is most likely only going to figure in government as a minority player in coalition. Forza Italia therefore have most to lose from the new electoral law (Italicum) ratified in July 2016. As a political quid pro quo, modifying the Italicum may lead Forza Italia to be more supportive of the referendum and most recent noise suggests Renzi is prepared to make a change.

What is the Italicum?

Importantly the Italicum is not directly linked to the referendum. Since July 2016 the Italicum is part of Italian law.

Italicum is Italy’s new electoral process moving to a dual round voting system. If a party gains 40% of the vote in the initial ballot they gain 54% of the seats, and therefore avoids the post 1940s Italian issue of weak government. If no party reaches 40%, then a second round vote takes place, 2 weeks later, with the electorate choosing between the two most successful single parties of the initial ballot. The winning party then gets 54% of the vote and the remaining seats are proportional as per the first ballot.

Since Renzi pushed the reform through, his popularity has waned and minority parties have been vocal that the rules should be changed for fear that their influence becomes severely diminished under this new system. A proposed amendment is to allow cross party coalitions to form the two alternatives on the second ballot. If Renzi proposes a reform to the Italicum, then it’s surely linked to support for his referendum.

To conclude, we believe this referendum doesn’t constitute a contagion risk for Europe because it isn’t about Europe, it’s about domestic Italian reform. Even in the event the Italian people vote No and Renzi did resign then it’s hard see a sustained negative impact on European equities given the already low exposure to Italy by international investors. Whilst a short period of market volatility is probable, we believe it’s wrong to see this as anything close to “Brexit 2”.

On the European team one of the valuation measures we use is Shiller, or cyclically adjusted earnings. Figure 2 below shows, Europe is at an 18% discount and the Euro area 36% discount to their long run averages, confirming much is already in the price. Specific to Italy, the market is already 60% below the historic median, a median that’s based on the status quo. If the Italian electorate do vote Yes and hence embrace change, then won’t there be a marked change in sentiment to Italy and stocks re-rate?

We believe there are good investment opportunities in Europe and haven’t changed our portfolios on the basis of the Italian referendum. We absolutely don’t see the Italian referendum as a fundamental risk to the Euro area or the European politics. As we have flagged many times before, we are seeing gradually improving economic conditions in Europe (PMI, employment, money supply, financing rates), which give us confidence in our positive, pro-cyclical positioning. We also note that in the past it has generally been a good time to make money in bottom-up stock picking when the market has become fixated with regional politics.

Oliver Collin – Fund Manager – Invesco