What Investors Should Know About the Italian Referendum

On Sunday, December 4, Italians will head to the voting booths in the next political drama to put investors on edge, following the populist votes to put Donald Trump in the White House and to take the U.K. out of the European Union.

Voters will cast their ballots for or against a referendum that consists of a constitutional reform that would strengthen the central government over local authorities and overhaul Italy’s legislature by shrinking the size of the Senate and stripping it of much of its power. Prime Minister Matteo Renzi contends these are necessary measures for overcoming political gridlock and would help pass crucial economic reforms in the euro zone’s third-largest economy and most indebted nation. Although there’s been lively debate over the merits of the reform package, for many Italians the referendum is really a vote of confidence in the Renzi administration: The prime minister has pledged to resign if he doesn’t get his way. Renzi has backtracked somewhat on his ultimatum, but a no vote will be seen as a vote against the status quo in a country that is showing increasing support for antiestablishment parties. It’s also a near-guarantee of further problems for Italy’s troubled banking sector, which is dogged by €350 billion ($371 billion) in bad loans, analysts say.

The most recent polls show the no vote with a lead of 5 to 8 points over “yes,” with a fifth of voters undecided; the markets put the odds in favor of the former. The FTSE MIB, the benchmark for the Borsa Italiana, Italy’s main stock exchange, has fallen more than 5 percent in November. The spread between Italian ten-year bonds and the benchmark German Bund has widened to over 1.7 percentage points, near the highest level in two years.

In the event of a no vote, analysts seem to expect Italy’s flagging banking sector to slide even further. The FTSE Italia Banche index has dropped by more than half since the start of the year. Shares in Banca Monte dei Paschi di Siena, the world’s oldest bank — and Europe’s weakest, according to July stress tests — are down 82.7 percent this year. Likewise, shares in UniCredit, Italy’s largest lender, have fallen 61 percent in 2016. Both banks have plans to raise much-needed capital that would be jeopardized by a change in government and the cloud of political uncertainty that would go with it.

According to Stephen Gallo, head of European foreign exchange strategy at investment bank BMO Capital Markets, the referendum is a lose-lose situation for Renzi. If the referendum fails, the prime minister may be out of a job. But if the referendum wins, “the result doesn’t change the underlying tone in Italy that is more support for antiestablishment parties,” Gallo says.

The proposed consolidation of the Senate following a yes vote, combined with rising support for the populist Five Star Movement — which scored big wins in city elections in Rome and Turin in June — would make it easier for the group to take over the legislature and advance an agenda that includes a U.K.-style referendum on EU membership.

As if the Italian job wasn’t enough, Austria is holding a do-over presidential election on the same day as the referendum. Independent candidate Alexander Van der Bellen beat his far-right rival, Norbert Hofer, in May by some 30,000 votes, but Austria’s high court overturned the result after Hofer’s Freedom Party — which has voiced support for a referendum to exit the EU — argued that postal ballots had been handled improperly. Polls suggest a tight race going into Sunday.

“Worst-case scenario: If Italy has a no vote and Austria swings to the far right, I think euro-dollar could lose 0.75 percent to 1.25 percent in a knee-jerk reaction,” Gallo says. (The euro has fallen about 4.5 percent against the dollar this year.) If Italy votes yes, Gallo sees a rally in the euro to 1.08 against the dollar — but that would be the time to sell, he adds, as he doesn’t expect the exchange rate to reach 1.10. It closed at 1.06 on Tuesday.

Although there’s no direct link between the Italian referendum and a vote to exit the EU — an “Italeave” or “Quitaly,” as observers have dubbed this possibility — and the immediate market fallout is likely to be tame compared with Brexit, Italy’s vote is no less significant.

“First and foremost, I think it would be a wake-up call that the sentiment we’ve seen in the U.S. and U.K. is very much alive in the rest of the euro zone,” says Gallo.