Investment strategy: Italy says no to reforms

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In Sunday’s referendum, the Italian people voted against reforms of the Italian Senate. Prime Minister Matteo Renzi offered his resignation, meaning that we are entering a period of political instability in Italy.

This represents an opportunity for investors to buy Italian government bonds. The purchase could be done at the expense of euro-denominated investment-grade credits.

Unlike the results of the UK referendum and US elections, the referendum outcome was in line with market expectations. Initially, we witnessed some price volatility in the euro and Italian securities, with little spill-over effects to European markets. All in all, this market reaction is small compared with what we saw right after Brexit and the US elections. 

We expect that Italian securities will continue to struggle in the near term, but fears for an Italian exit from the eurozone are overdone. 

Political uncertainty reigns in Italy

We have entered a period of political instability in Italy. The referendum had morphed into a confidence vote on Prime Minister Renzi. He has offered to step up as soon as it was clear that the no camp had won by an overwhelming 60%. His resignation has not been accepted yet by Italian President Sergio Mattarella. Nevertheless, this may open the door for a caretaker government and possibly trigger early elections. 

The latest polls show that an early election could sweep the populist and anti-euro Five Star Movement into power. The same no vote, however, means that reforms to the Senate will not take place. As such, Italy continues to have a parliamentary system where the Lower house and the Senate enjoy equal power. This effectively means that no single political party can dominate legislative power. Fears of an Italian exit from the eurozone may run high in the aftermath of this referendum, but are therefore overdone.

Restructuring banks now more difficult

The vote against reforms means a roadblock for the recapitalisation of banks with large non-performing loans, of which Banca Monte Dei Paschi di Siena is the most important. Private parties that previously had expressed their willingness to step in, may hesitate -or in the worst case- even step back. The Italian government may then have to bail out these banks. This is against the will of the European Union that insists on bailing in bond holders. All this will reduce confidence in Italian banks.

Market price weakness may spill over to the European banks and euro-denominated investment-grade bonds, but this may be more sentiment than fundamentals. In contrast to Italian banks, European banks have been able to strengthen their capital base over the last few years. 

S&P may downgrade Italy to a speculative rating

The no vote also means a halt to structural reforms of the economy which Italy desperately needs, since its economy is flat-lining and the pile of debt is high. The bleak outlook for the government debt and the Italian economy may trigger credit rating agency S&P to downgrade Italy from BBB- to a speculative credit rating. 

S&P has had Italy’s credit rating on negative watch for some time. For now, the credit rating of Italy with credit rating agencies Moody’s and Fitch is investment-grade with a stable outlook. Therefore, the wider implications of an S&P downgrade, if it were to happen, are fairly limited and not expected to be immediate. 

Italian securities will struggle

Already in the run-up to the referendum, financial markets were leaning towards this no outcome. Italian government bond and equity prices had fallen behind their benchmark. 

The market reaction following the outcome of the referendum was therefore relatively calm. The euro is even slightly up against the US dollar and also European equities, including Italian financials rose by around 2%. Still, we expect political uncertainty to remain a drag on the performance of Italian equities, government bonds and bank bonds. 

What can investors do?

We expect Italian government bonds to suffer further weakness. Investors can consider buying Italian government bonds as the current high spread levels are attractive. We regard fears of Italy leaving the eurozone as overdone. 

We advise caution with respect to Italian bank bonds. Price weakness of bank bonds could be a short-term drag on euro-denominated investment-grade corporate bonds. Investors could finance the purchase of Italian government bonds from investment-grade credits denominated in euro.

Didier Duret, Chair, Global Investment Committee
Gerben Jorritsma , Global Head of Investment Strategy & Portfolio Expertise 
Mary Pieterse-Bloem , Global Head of Fixed Income Strategy


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