December 3, 2016    8 minute read

Political Economy Redux

The Italian Conundrum    December 3, 2016    8 minute read

Political Economy Redux

Once upon a time it used to be enough for investors to spend the majority of their time pondering economic trends in order to anticipate the future direction of financial markets, with only occasional interludes to reflect on the impact of political events. Not anymore. As suggested at the start of this year, 2016 has been all about politics and two words, “Brexit” and Trump” – two major surprise outcomes (much less of a surprise to readers for the reasons outlined in several recent Market Insights) – have dominated the world of finance.

One Bad Year

As 2016 enters the home straight the collective sigh of relief that “thank goodness this is nearly over” is palpable. Unfortunately, political uncertainty and its associated risks are not going to disappear anytime soon. Indeed, there are major European political events looming on the near horizon.

Most immediately, there is the Italian constitutional reform referendum slated for December 4th. With PM Renzi having promised to resign in the event that he fails to secure victory this has, in effect, become a confidence vote in his government. Given the souring in the public mood towards the status quo and incumbent politicians across many developed nations, such an Oydessean campaign tactic may well backfire, leaving Italy bereft of both political reform and a prime minister.

According to opinion polls published just prior to the mandated blackout period, the No campaign had a commanding lead – ranging between 5-10 percentage points depending upon the poll – despite support from leading Italian celebrities. Even though the lead is below the number of undecideds the indication from the polls is fairly clear cut – Renzi will lose.

That said, given how abysmal opinion polls have been at predicting the outcomes of political votes this year (and earlier – notably the polls were also wide of the mark in predicting the last UK general election) it is awfully tempting to go with a Yes victory purely on contrarian grounds.

Learning From Brexit And The US Election

The preference, of course, is to rely on the signals from crowd-sourced sentiment indicators given they accurately flagged both the UK referendum and US presidential outcomes.

In exactly the same manner used for tracking public moods towards Clinton and Trump, one has been monitoring government anger in Italy on the premise that rising crowd anger towards the Renzi government is a negative signal for the referendum given the Oydessean strategy adopted. Conversely, falling crowd anger towards the Renzi government is taken to be a positive signal for the referendum.

As can be seen in the exhibit below, a recent Amareos tweet included a chart showing how the crowd-sourced sentiment has evolved on social media.


(Chart 1: A Recent Tweet; Source: Amareos)

In recent weeks there has been a sharp escalation in anger towards the Renzi government in social media posts. Notably, this increased crowd negativity towards the Italian government is largely absent from the mainstream media; a similar divergence in the tone of the two media types was also observed in the final throes of the US presidential campaign. Nevertheless, in aggregate, it implies that this time around, unlike the UK referendum and the US election results, the crowd-sourced sentiment indicators are confirming the message from the polls.

Sentiment Towards The Government

Government anger is one of the components of the sentiment-based measure of political risk as described in an earlier Market Insight. Hence, the surge in negativity towards the Renzi government evident in social media has contributed to pushing up the Italian Political Risk indicator to its highest level in the post-2010 period. This escalation in political risk has been echoed by the jump in the BTP-Bund spread over recent weeks (see exhibit below) suggesting Italian asset markets – government bonds at least – are already priced for a negative outcome.


(Chart 2: Italian Political Risk vs. 10-year BTP-Bund Spread; Source: Amareos)

Nevertheless, in the event of a No vote and the probable resignation of Renzi as prime minister, some have speculated that this would be analogous to the Brexit vote – namely that it could signal Italy’s eventual exit from the EU, and obviously and logically, its membership of the single currency.

Such an eventuality would not only be extremely damaging for Italian financial markets and its economy but for the entire eurozone. This is because an Italian exit would see investors quickly focus on the obvious structural deficiencies of the French economy putting the eurozone’s already straining institutional framework under such immense pressure that it would be unable to withstand it. And, without France, the single currency project makes neither economic nor political sense.

Not The End Of The World

Such pessimism is unwarranted. Sure, a No vote would serve to further undermine confidence in Italy’s political reform process and its asset markets. However, as per the above exhibit, a negative outcome appears to be largely priced in, suggesting limited additional downside. Hence, it is highly unlikely that voters rejecting Renzi’s referendum and triggering his resignation as PM would be, of itself, enough of a negative shock to put Italy’s membership of the single currency in jeopardy.

Moreover, the legislative path to Italexit is rather complex. The Italian constitution, for example, does not allow for international agreements to be rescinded by referendum. Hence, constitutional change, requiring a stable and solid government, would be a necessary first step. While a No vote would likely further embolden the populist, Eurosceptic, anti-establishment M5S party it is far from certain that they would immediately push for a “consultative” referendum on their participation in the single currency.

In a blog post published on the day the UK realised it had voted for Brexit, Beppe Grillo, the party’s founder, softened his rhetoric against the EU arguing that his party has “no intention of abandoning the community of the European Union”, but was seeking “reform from within”.

The Impact Of A ‘No’ Vote

More likely, the impact of a No vote would be a Renzi resignation followed by a caretaker government – hardly an unknown in Italian politics – one that could conceivably be headed by Renzi if President Mattarella refuses to accept his resignation, although Renzi his rejected such suggestions.

Consistent with this less extreme assessment of the implications of a likely No vote, crowd-sourced Fear sentiment in Italy, while higher over the past few months, is significantly lower than the record highs recorded during the height of the EUR crisis. It is also significantly below the levels witnessed in the UK in the run-up to the Brexit vote. The same is also true of Italian economic growth sentiment.


(Chart 3: Fear Sentiment – Italy; Source: Amareos)

Obviously, public perceptions are fluid and can change dramatically in a short space of time as one saw in the last Market Insight with US inflation sentiment surging after the Trump victory. As of now, though, the crowd-sourced sentiment indicators are consistent with a No vote in the December 4th constitutional reform referendum, but for this not to constitute a catalyst for imminent Italexit (surely there is a better phrase than this – any suggestions gratefully received).

That said, irrespective of the outcome of the Italian referendum, eurozone financial markets will remain hostage to political uncertainty because of the slew of national elections scheduled to take place over the course of the next year and whose outcomes are far from certain.

Movement In Austria Too

The same day as the Italian referendum, Austria holds a second presidential vote after the previous vote held in April was nullified due to postal voting irregularities. Last time around the result was extremely close between Van der Bellen (former Green Party now running as an independent) and Hofer (leader of anti-EU far-right Freedom Party). Therefore, it is very conceivable, given the tailwind from Brexit and Trump, that another ardent critic of the single currency project gains a position of power. (Although largely ceremonial, the presidency would present a useful platform for the Freedom party to lead a government – as Van der Bellen has warned.)

Moreover, next year, investors face the gauntlet of Dutch general elections in March, French presidential elections in April, and German federal elections in September/October.

The Ever-Surprising Politics

As last week’s French preliminary conservative candidate vote showed there is plenty of room for surprises. Former President Sarkozy, who has been desperately seeking a way back into frontline politics, was unexpectedly knocked out in the first round of the vote, while front-runner Juppe came up short against the unexpected victor, Fillon. Hence, it now seems that Fillon is best placed to run against Front National’s Marine le Pen in next spring’s presidential election given the socialists are in complete disarray with current President Hollande still deciding whether to run even though his dismal approval rating points to little hope of success (since the time of writing Hollande has confirmed he will not run for re-election).

The readers will, of course, be helped to navigate this challenging political landscape using the lens provided by the crowd-sourced sentiment indicators, which as has been amply demonstrated this year, have a much better track record at anticipating political outcomes than the polls.

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