Italy ‘no’ vote could spark EM risk aversion

A ‘no’ vote in Italy’s constitutional referendum this coming Sunday would likely spark a short-term ‘risk off’ move by global investors, including in emerging markets, warn fund managers. And that may be the least of their concerns, in light of banking-sector problems and a rising tide of populism in Europe.

Meanwhile, the direct impact on Asian investors of a negative referendum vote – which polls suggest is the likely outcome – is not likely to be marked, suggest portfolio managers.

Yet the direct impact on Asian investors would be greater in the more export-oriented economies (such as China and Korea), which are already struggling with slowing exports, said Raj Shant, global equities manager at Newton Investment Management.

Meanwhile, all eyes will be on the open of Asian trading on Monday – in particular New Zealand  –for an indication of early market moves.

What’s at stake

The vote is on whether to give Italy's lower house of the parliament sole power to approve reforms by heavily reducing the power of the upper house (the Senate). Italian prime minister Matteo Renzi believes this would speed political decision-making and has repeatedly said he will step down if the proposal fails to win support.

His departure would lead to further political instability that would have a negative impact on markets, at least in the short term, say fund managers.

“In the event of a ‘no’ vote, we view Renzi’s decision on whether to resign as the primary driver of risk markets,” said Sabrina Wong, a London-based portfolio manager at Columbia Threadneedle. “Renzi has been a strong and vocal proponent of achieving a bondholder-friendly solution to the sizeable issues faced by the Italian banking system.”

Banking troubles

In the case of a ‘no’ vote, badly needed banking recapitalisations would probably fail, because investors may refuse to back Italy’s financial sector amid increased turbulence. In such a case, the state would have to intervene to stave off collapse.

This is a big deal, given that Italian banks hold around E360 billion ($381 billion) of bad loans, roughly 40% of all non-performing loans (NPLs) in the eurozone, according to Reuters.

NPLs accounted for 18% of total gross loans last year, trebling from 6% in 2008, noted Aymeric Forest, Europe head of multi-asset investments at UK fund house Schroders. He added that Italian banks and bonds had already underperformed going into the referendum.

The European Central Bank is likely to continue to intervene to dampen volatility through its bond-purchasing programme, said Forest, but this may put additional downside pressure on the euro.

However, said Shant, “if the contagion of bank failures were to spread from the banks to government and from there to the euro … it is hard to imagine the Germans can allow the ECB to step in to intervene on an even bigger scale than it is doing at present.” For example, Germany has a general election coming up next year.

A ‘yes’ vote no easy solution

“But even a ‘yes’ vote wouldn’t resolve the mountain of unprovisioned bad loans on the balance sheets of many Italian banks,” added Shant.

Whatever the result of the referendum, agreed Forest, Italy must undergo significant reforms to avoid repetitive volatile events affecting its equity and bond markets.

As regards investment positioning, he said his portfolio tended not to own Italian bonds or it hedged the duration risk. He also limits exposure to Italian stocks, preferring the US financial sector.

Moreover, Forest has been either fully hedged or slightly short the euro, preferring the US dollar. “The decision is driven by interest rate, inflation and growth differentials as well as political issues,” he added.

Populism fears

Indeed, beyond Italy’s banking-sector worries, there is a wider concern that the country will be caught in a populist current like that which helped contribute to the Brexit vote in June and the election of Donald Trump in the US on November 8. The anti-establishment, anti-EU and anti-euro Five Star party has been gaining traction.  

As Philip Dicken, head of European equities at Columbia Threadneedle said in a report published yesterday: “The referendum in Italy and the uncertainty around it will be just a chapter in this story with other events to come, both in Italy and other European countries. Political risk is on the rise and investors need to get used to it.”

Asian investors may be used to political risk in their own continent, but less so in the West. They may need to review their thinking.