The Italian Referendum: What is pricing in?

Less than ten days ahead of the US Presidential election, market focus on the Italian Referendum is much on the sideline. Nevertheless, the Referendum on 4 December represents a pivotal moment in terms of potential larger scale implications on the future of the entire European Union.

Trying to gauge global market expectations on the referendum outcome, according to prices and valuations changes on the Italian assets, is definitely complex, to a large extent due to the unpredictable path of the future Italian political scenario, should the “No-Vote” campaign prevail. However, some reasonable arguments can be outlined, connecting the dots among market commentaries, the evolution of the political debate in Italy and price changes on the Italian assets over the recent months.

On April 2016, after the referendum announcement, prime minister Matteo Renzi announced his intention to bet his premiership on the constitutional reform, the first pillar of his comprehensive reform package. Over the following months, both sell side and buy side analysts released research reports on potential consequences of a "No-Win" victory on the future of Renzi's government, in a close comparison with the June UK vote. The message is clear: a potential Renzi's resignation would lead the way to new elections, with realistic chances of victory by the Five Stars Movement, the main opposition party, which repeatedly expresses the intention to launch a European referendum on the Euro and the actual monetary union.

More recently, Prime Minister Renzi partially stepped back from his resining intentions. Nevertheless, the damage is at least partially done and the more time goes by, the more this reform has been being perceived by the public opinion as a vote on government’s activity. However, the question remains: what is the market really pricing in, in case of a government step down? If we compare the main Italian equity index, the FTSE MIB 40, to its european peers, there is a clear underperformance on YTD basis. However, much of such underperformance is attributable to the domestic focus of the index components, largely made of financial institutions and energy companies with a very limited international exposure

Moving from the equity space to the fixed income one, a more interesting message comes from the government bond spreads, comparing the 10Y generic BTP to the Spanish 10Y generic BONOS. Since 2008, the BTP-BONOS spread has been a quite reliable indicator of the relative political stability within these two countries. Therefore, there is no surprise in observing BTP's underperformance since the referendum announcement (April 2016)

In conclusion, the Italian political outlook remains still very unclear and such uncertainty seems to be priced into the government bonds space. In addition, if we take into account that Spain is moving towards a more stable political outlook, following the recent formation of a minority PP-PSOE government, and Italy is approaching the Referendum date, there are reasonable chances for the BTP-BONOS spread to continue to move higher over the next few weeks.