Update on Italian Referendum

051216 Market Commentary

Update on Italian Referendum

Executive Summary

The “NO” vote to the Italian referendum will further weaken the euro, affect the European Bond Market and lead to political uncertainty in Italy Political risk remains a key issue for European Equities but must not be the tree that hides the forest, some positive factors are in place ECP has a selective approach of the European Equity markets focusing only on companies showing an undervalued earning power Current positioning in Italy will not be dramatically affected by the current political events
 “Things come in threes” as the saying goes…After Brexit and Trump, we are now facing a third political surprise this year…   While the election results in Austria came as a relief, Italy creates further turbulence. The referendum ended with the assertion of NO in higher than expected proportions (59% vs. 41%) and with a very strong turnout (close to 66%). We suspect this was more a vote against Matteo Renzi than a vote against Europe but hence, consequences will not only affect Italy. The 1st lesson to be learnt from this new political storm is that future leaders should stop to link their professional careers to the outcome of a referendum!

What are the probable consequences?

  It is worth to point out that for the Brexit vote and Trump election, Equity markets actually rose due to a weakening GBP and expectations of a massive spending plan. In this specific case, we can anticipate the following:
  • The NO vote has dealt a new blow to the European project and a weaker Europe means a weaker euro
  • Yield spreads to PIIGS countries will widen again against the Bund putting further pressure on the foundations of the Monetary Union
  • ECB stands ready to address financial stability in the region with a potential extension of its QE program
  • Italy could suffer a rating downgrade forcing Italian banks to post more collateral when Italian Government Bonds are offered as collateral
  • Banking sector will find it tougher to recapitalise
  • Increased political instability in Italy will make the country difficult to govern: implementation of the necessary reforms will be challenging while competitiveness will be harder to restore
  • In light of the complexity of the Italian political system, we do not believe that a populist party like “Movimento 5 Stelle” will be able to impose a referendum on Italy to exit EU in the near future.

What is the potential impact on our European strategies?

  Generally, political risk still dominates the headlines and investors’ concerns. While this risk must not be underestimated, we think it should not hide the positive factors that are also in place:
  • After almost USD 100bn outflows till end of November, European Equities looks under-owned. With high valuations in the US and rising bond yields, the asset class is, from our point of view, gaining some traction.
  • After 10 years of earnings recession, there are signs of life in European Corporate sector
  On the micro level, European companies have been focusing on their businesses and restructured to adapt to a difficult environment while on a short-term horizon, a weaker euro will provide a strong profit engine.    Our “Entrepreneurial Value” approach does not buy Europe or Italy as a whole stock market but aims to invest in a selection of 30 to 40 companies presenting undervalued earning power. This strategy leads us to move away from the reference index. As illustration, we are not invested in the Italian Banking sector since we sold our position in Unicredit end of last June. Despite low valuations, this sector presents many risks making it difficult for us to have an opinion on their future earning power. Our portfolio currently owns 2 Italian companies, namely the pencil producer Fila and the steel plant builder Danieli. We do not anticipate any major impact of the recent vote on both companies as they do not carry a high bond risk and are not so dependent on their domestic markets. In our hedged strategy, we continue to err on the safe side by hedging 70% of our long book.