The next step in the global populism trend could be felt December 4. This is when the Italian referendum to change the constitution, a measure supported by the political establishment, will be voted up or down. A Moody’s report notes that rejecting the referendum could “contribute to global financial market uncertainty, and greatly add to the concerns surrounding the restructuring of the Italian banking sector.” A Deutsche Bank report, however, only handicaps a 40% chance of the vote succeeding. To various degrees, bond markets are already moving in anticipation of a rejection of the measure, but the real concern is a populist victory leading to rejection of the European Union in 2018.
Moody's chart: Italian economy weak and in need of improvement
Italian Referendum Seeks to Streamline Government, Reduce Waste
With its banking sector on the edge of instability, Italy is facing high unemployment and economic stagnation amid chronic government waste problems; government bond yields have been spiking on a relative basis. Solving the problem won’t be easy and may require less, not more, democracy. This is both the problem and primary concern behind the Italian constitutional referendum.
“The great hope behind the Italian referendum is that its success can lay the groundwork for structural reforms and stimulus spending that would boost the moribund economy,” said a November 15 Moody’s report titled “Will Italy Get Trumped?”
Italian Prime Minister Matteo Renzi has placed his political future on the line with measures designed to streamline what Moody’s analyst Benjamin Garber calls “the notoriously chaotic Italian Parliament” with the goal to consolidate power and reform the system.
Deutsche Bank chart: Probability paths
Populist Group Opposes Italian Referendum
It is the consolidation of power that the Italian referendum could bring that populist groups such as Italy’s maverick 5 Star populist political movement fears. The populists are currently running “well ahead” in polls on the basis of opposing the political establishment in what they say is an elite power grab.
If passed, the referendum would reduce the size and influence of the Senate and in the lower house give more power to the majority and strengthen the central government. Power to determine and implement government spending would also be shifted from regional officials to the central government.
The structural changes are seen in part as quelling dissenting minority influence from the extreme right and left, critics charge. Faced with difficult budget choices amid a government debt to GDP level north of 130%, proponents note the current system avoids making tough but necessary fiscal choices and stifles needed reforms.
Deutsche Bank chart: Real concern is leaving the EU
Worst-Case Scenario: Election of a Populist Government, Rejection of EU
Playing out various probability paths in a November 11 report titled “Italy’s referendum and beyond,” Deutsche Bank painted a dire worst-case scenario. If the constitutional changes are rejected it might lead to a populist government in 2017, followed by a referendum on Euro area membership, which could threaten the European project as a whole.
While such a “tail-risk outcome cannot be fully discounted,” if the referendum fails the probability path is likely “more benign,” with a new electoral law followed by early elections. “This would significantly reduce the risk of a populist government and a referendum on Euro area membership,” Wolf von Rotberg and his Deutsche Bank team wrote.
Regardless of the outcome, Deutsche Bank isn’t entirely positive near term. “We expect neither major reforms nor a systemic solution for the banking sector before the next election. Hence, the economy and banks will continue to be vulnerable to negative shocks.”
Bond Market Already Reacting to Potential Election Outcome
Those negative shocks are already visible in the sovereign bond market, Moody’s notes.
Interest rate differentials between Spanish and Italian government bond yields – two traditionally highly correlated markets – are beginning to diverge.
The yield on the Italian 10-year government bond at 1.74% is now 48 basis points above the Spanish ten year, close to the largest spread in the past four years. Moody’s notes that the largest spread increase occurred on June 27, days after the Brexit shock, pointing to market participant’s concern for a similar event in Italy.
Credit default risk is also noted in credit default swaps. According to Moody’s Analytics, Italy’s 5-year sovereign CDS-implied EDF (expected default frequency) is at 0.52%, “significantly worse” than Spain’s 0.21% reading. “Italy now carries a larger gap with Spain’s CDS-implied EDF measure than it does with Portugal’s 0.78% reading, the report noted with concern. Portugal correlates to Italy on a fundamental basis due to a weak banking sector, heavy government debt burdens and “extremely modest growth outlooks.”
A significant difference between Brexit and the Italian referendum, however, is that bond market signals are already pointing to a populist victory. When an outcome is generally known, surprise is removed and market price volatility is often reduced if not eliminated. The larger concern would be a spread of populist fervor that leads to Italy leaving the EU, which could create significant stock market volatility, Deutsche Bank noted.
By Mark Melin
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