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Investment Research — General Market Conditions 22 November 2016 Research Italy No ‘Italexit’ in the case of a ‘No’ in the referendum On 4 December, Italians are set to vote on the constitutional reform proposed by Prime Minister Matteo Renzi. The aim of the constitutional reform is to bring political stability to Italy by diluting the power of the senate and the regions, thus empowering the government. Supporters of the bill argue that the new constitution would bring much-needed political stability (Italy has had 63 governments since 1945) and allow governments to push through important growth-enhancing reforms, which might otherwise be rejected by the senate. Critics argue the government will become too powerful and that the issue is not passing reforms but executing them in the inefficient bureaucracy. The referendum has more aspects than the constitutional bill – not least with increasing EU scepticism and following the UK’s Brexit vote and Donald Trump winning the US election. Originally, Renzi announced that he would step down if he loses the vote but later members of the coalition said the government would stay in place. Over the weekend, Renzi’s resignation seemed to be confirmed in the case of a ‘No’ vote, as he said the government would fall if he loses the referendum. Polls from the end of October suggest the referendum is likely to be rejected by around 52% ‘No’ votes on average but some polls suggest up to 50% of the population has not decided. Observers note that the referendum has become a way for the population to express discontent with Renzi’s government, the 2017 budget and growth initiatives. The outcome of the referendum is of high importance for the Italian economy and European market sentiment. If accepted, the bill could boost confidence in the recovery of the Italian economy, create political stability and reduce uncertainty about the future of the euro area. Italy has been one of the worst performers since the financial crisis. Contrary to most euro area economies, Italian GDP has still not returned to its pre-crisis level and the country is coping with a large public debt and deficit (respectively 132.7% and -2.6% of GDP) and a high share of non-performing loans (18% of total loans). On top of this, Italy has Europe’s fifth highest unemployment rate (11.7%), a very high youth unemployment rate (37.1%) and low productivity. Accepting the bill should boost the government’s ability to cope with these issues but depending on the political development and the design of the new electoral law, the Five Star Movement could gain power in the next election (see more on the following pages). However, if rejected, the referendum could throw Italy into new political disarray and increase uncertainty stemming from the rising euro scepticism across the euro area. According to the Italian government and other economists, 2017 growth will fall from 1% to around 0.6% without the budget and growth-measures suggested. Additionally, the political uncertainty that arises around the future of Renzi’s government could hurt market sentiment as the influence of the Five Star Movement could increase (see more below). The Italian population is already among the most sceptical regarding the euro (see Unchanged support for the euro before Brexit but optimism about EU’s future is lower, 1 August). Key facts Population (2016): 60.7m. GDP per capita (2015): EUR27,000, ninth highest in the euro area. Government type: Republic with an upper house (Senato della Repubblica) and a lower house (Camera dei Deputati). Government coalition: PD, NCD, UdC, SC, Ppl, Demo. S, PSI, CD. Prime Minister: Matteo Renzi, Democratic Party (PD). President: Sergio Mattarella. Central Bank Governor: Ignazio Visco. Economic characteristics GDP still below pre-crisis level. Large public debt. High youth unemployment. High degree of political instability. Struggles with corruption. Troubled financial sector. Senior Analyst Pernille Bomholdt Henneberg +45 45 13 20 21 [email protected] First Year Analyst Aila Mihr +45 45 13 78 67 [email protected] Assistant Analyst Christian Belling Sørensen [email protected] Important disclosures and certifications are contained from page 10 of this report. www.danskeresearch.com Research Italy Scenarios after the referendum – market reaction dependent on the political path Referendum on Italy’s constitutional reform ‘ YES’ ‘NO’ Initial positive market reaction Initial negative market reaction Renzi continues growth reforms. Work on new electoral law Renzi stays PM Renzi steps down President Mattarella rejects Renzi’s resignation Strong support for Renzi government Election in 2018 based on revised Italicum Weak support for Renzi’s government Renzi is not likely to take part in new government President Mattarella accepts Renzi’s resignation New government/coalition serving as placeholder until election in 2018 Focused on new electoral law. No reform progress Renzi gets second term with more government power Care-taker government and snap election Snap election in H2 2017 based on revised Italicum Coalition government The Five Star Movement emerges into power Positive market reaction. No/little uncertainty about Italy’s future in euro / EU Snap election in H1 2017 based on current Italicum Strong reform progress. Work on new electoral law Negative market reaction. Uncertainty about Italy’s future in the euro / EU Source: Danske Bank Markets Political impact of a ‘No’ vote The big question in the case of a ‘No’ vote is whether Prime Minister Renzi will honour his initial pledge to step down or stick to his later stance that his initial comment was a mistake. Although Renzi has declined to comment on this question for the past two months, there have been some signals that stepping down is a very likely outcome. On 14 November, he indicated that he may not stay on if the referendum fails, saying that he would not take part in any attempt to form a temporary or technocratic government. A resignation by Renzi in the case of a ‘No’ vote was also confirmed by his latest remarks on 20 November that the government would fall if he loses the referendum and that we would then have to see which parties can reach agreement for a new government. Referendum polls showing ‘ No’ vote in the lead (undecided not included) Source: Macrobond Financial, Danske Bank Scenarios and related probabilities following a ‘No’ vote Renzi steps down Renzi steps down Renzi stays PM No elections before revised 'Italicum', but technocratic transition government Early elections in H1 17 under current 'Italicum' and Five Star Movement in government Weak and fractured PD government Baseline scenario 70% Alternative scenario 1 5% Alternative scenario 2 25% Source: Danske Bank Markets 2| 22 November 2016 www.danskeresearch.com Research Italy If Renzi resigns, President Sergio Mattarella would be likely to nominate an interim government before dissolving the lower house and calling early snap elections for 2017, as elections should be held within 70 days of the President dissolving Parliament. Predicting the outcome of such an election is complicated and is likely to be highly dependent on whether or not the new electoral law – ‘Italicum’ – will still be in place in an unchanged form when the election takes place. Given that Renzi has said that Italicum will be changed no matter what the outcome of the referendum and that there is broad political support for such a move, it is likely that snap elections for 2017 would not proceed under the new electoral law in its current form. With a revised electoral law that excludes the majority bonus for a single party, we would be likely to see again a coalition government in place, limiting the chances of the Five Star Movement gaining power (see below). Facts about Italicum – the new electoral law The aim of Italicum is to prevent governments of unstable coalitions, as Italicum gives the party winning at least 40% of the votes in the first round or winning a second round between the two biggest parties, a large number of bonus seats to ensure it has a 54% majority (340 out of 630 seats) in the lower house. Italicum entered into force in July but the constitutionality of the new law has been challenged in the constitutional court and a final ruling is not expected before early next year. Italicum will be revised regardless of the outcome of the constitutional reform on 4 December. Renzi has stated that Italicum will be changed and there is a broad political support for this. In the case of a ‘No’-vote, rejecting the government’s reform plans would make it more likely that the Italicum would be abandoned altogether and it is likely we would see a return to the old proportional representation electoral system also used in the Senate. In case of a ‘Yes’, this would reduce pressure on the government to amend the Italicum; however, there seems to be broad support among the PD and some opposition parties for revising it towards a majority bonus for a coalition instead of a single party, to minimise the risk of anti-establishment parties coming to power after the next general election. Given the Five Star Movements’ opposition to forming coalitions, such a move would severely weaken its chances. Source: Danske Bank Markets However, in the event that the election should take place very early in 2017, before the final ruling of the constitutional court, there is a risk that voting could proceed under the Italicum in unchanged form. Should voting proceed under the new electoral law without changes, it would benefit the anti-establishment Five Star Movement. By capturing as little as 30% of the popular vote in the first round, it could end up with a clear majority in the lower house, by winning the second round run-off and receiving the bonus seats. Currently, the Five Star Movement is head-to-head with the PD in most opinion polls, making it still a likely candidate for the next government in the absence of certainty on planned changes on Italicum. Members of the movement were already elected as mayors of Rome and Turin in 2016. Although the Five Star Movement has pledged a referendum on the euro, it has stopped short of advocating an immediate exit from the EU. Furthermore, it is not clear that if such a referendum were held, the majority of Italians would vote in favour of an exit, as support for the EU among the population actually increased after Brexit according to an IFOP poll. An imminent ‘Italexit’ therefore seems unlikely for now. 3| 22 November 2016 Polls show Five Star Movement headto-head with Renzi’s PD % 40 35 30 25 20 15 10 5 0 Five Star Movement PD Source: SWG, Danske Bank Markets www.danskeresearch.com Forza Italia Research Italy Apart from calling new elections, President Sergio Mattarella has other options to resolve a potential political impasse following the referendum. He could reject the resignation of Renzi if he can command a majority in parliament, replace him with a technocrat as happened in 2011 when Mario Monti replaced Silvio Berlusconi or grant someone else the right to form a government. If the other parties in the governing coalition support such a move, the caretaker government would then take over until the next scheduled general election in 2018. However, given that Renzi has said that he would not be willing to seek a deal with other parties to form a temporary or technocratic government if he loses the referendum, such a move seems unlikely. A low share is against the euro in Italy 90% Ratio being against the euro as a common currency 80% SE 71% UK 76% DK 65% 70% 60% 50% 40% Finally, Renzi could decide to stay as Prime Minister, as he is aware of the likelihood of the Five Star Movement winning an early election, particularly as its momentum should be strong after a ‘No’ in the referendum. In this scenario, Renzi’s party’s popular mandate would still be dramatically weakened but the hope would be that ‘something’ could change ahead of the election in 2018. This said, divisions within the PD party between Renzi backers and traditionalists such as former PD leaders Massimo D’Alema and Pier Luigi Bersani, who criticise Renzi for moving the party too far to the right, pose the risk of a weak, fractured government and a slowdown of reforms, potentially leading to a government crisis and early election in 2017. GR 34% 30% BE 20% 20% FI 20% NL 21% DE 22% FR 24% AT 25% PT 26% EA 26% IT 35% EU 38% SP 27% IE 13% 10% 0% Source: European Commission Eurobarometer, Danske Bank Markets Timeline after a ‘No’ vote ‘No’ vote in referendum 04-12-2016 Interim government and new election 2nd half 2017 Snap elections if no government 12-12-2016 + 70d Renzi steps down as PM 05-12-2016 Parliament approves reform bill 12-04-2016 Obama endorses ‘yes’ 19-10-2016 Government sets referendum data 26-09-2016 Q2 2016 Q3 President accepts Renzi’s resignation 12-12-2016 Q1 2017 Q4 Politicians working on changing ‘Italicum’ First part of 2017 Q2 Q3 Latest date for new election 23-05-2018 Q4 Q1 2018 Today Source: Danske Bank Markets Economic impact of a ‘No’ vote According to the Italian government, GDP growth in 2017 will fall by 0.4pp without the suggested budget and growth-measures. Added to this, there could be some negative impact from higher political uncertainty but, in our view, the short-term effects of higher political uncertainty may not be that large in Italy, as the country is used to political instability, implying a likely small impact on consumer and business confidence. Additionally, the experience from the Brexit vote and the US election is that a new political agenda will not affect economic sentiment to a large degree. Finally, having a caretaker government for a period of time would not necessarily be negative for the near-term growth outlook or implementation of economic reforms. Based on this, we expect limited economic impact in the short term. 4| 22 November 2016 www.danskeresearch.com Q2 Research Italy In a longer term perspective, the political instability connected with a ‘No’ vote is likely to imply fewer structural reforms and continued problems in terms of bringing the economy to a solid recovery. Italy is also likely to continue to be challenged by bringing down its very high public debt, while the fragile banking sector could also have a negative impact on the economic outlook. Market reactions In our view, a ‘No’ vote would mean prolonged uncertainty for global investors and trigger political turmoil. Uncertainty on ‘what is next’ is likely to cause elevated volatility and further shake confidence in the European project. A ‘high’ political risk premium is already priced in the Italian government bond market with Italy having underperformed Spain by 30bp since early September, mainly on political woes. Renzi himself said that he expects high market volatility in the run-up to the referendum. Given Italy’s sizable government debt (130% of GDP) and the possibility of a slowdown in reforms and growth, questions about the direction for Italy (and Europe) have the potential to drive global risk sentiment around the referendum date. These fears could spill over to other periphery countries. The political impasse would also heighten concerns about Italy’s banking system, with its large share of non-performing loans. Economic and political uncertainty would weigh on the EUR and depress investments and future potential growth. This said, the market reaction is very dependent on the political path following the ‘No’ vote. As spreads have already widened significantly ahead of the referendum, we do not rule out that we could see tightening even in a ‘No’ scenario (‘sell the rumour – buy the fact’). Yields have been rising since August in anticipation of the referendum Outlook for key economic variables Source: Macrobond Financial, Danske Bank Italy - Outlook for key economic variables Italy GDP (1) CPI (1) Unemployment (2) Govt. Budget (3) Govt. Debt (3) 2016 2017 2016 2017 2016 2017 2016 2017 2016 2017 Danske Bank 0.8 0.9 -0.1 1.3 11.5 11.3 -2.5 -2.0 132.9 133.0 IMF 0.8 0.9 -0.1 0.5 11.5 11.2 -2.5 -2.2 133.2 133.4 OECD 0.8 0.8 0.2 0.9 11.3 10.8 -2.3 -2.0 132.8 131.9 EU (Commission) 0.7 0.9 0.0 1.2 11.5 11.4 -2.4 -2.4 133.0 133.1 1) % y/y. 2) % of labour force. 3) % of GDP. Source: OECD, IMF, European Commission, Danske Bank Markets What does the Five Star Movement stand for? The Five Star Movement (M5S) was founded by comedian Beppe Grillo and IT executive Gianroberto Casaleggio in 2009. M5S has become Italy’s second most popular party and its biggest opposition group, as support for the movement’s push for direct democracy and its anti-establishment and anti-corruption campaign surged among the population. At the previous lower house elections in 2013, the M5S took 25% of the vote. Within the movement, online ballots are used to set policy and select and expel candidates and it plans similar online referendums on political issues once in government. In contrast to other populist movements in Europe, which are clearly associated with either the political right or left, M5S has attracted votes across the political spectrum. While left-wing voters respond to its pro-environment, anti-austerity and anti-capitalist stance, right-wing voters are attracted by its tough stance on immigration and opposition to the EU and euro and its alliance with other right-wing parties in the European Parliament, such as UKIP. However, this characteristic also makes the movement vulnerable to internal clashes, as left- and right-leaning members increasingly seem to disagree on policy and issues such as privatisation or abortion. 5| 22 November 2016 www.danskeresearch.com Research Italy Apart from internal fragmentation, another big challenge for the movement comes in the form of its electoral candidates’ inexperience in questions of governance, politics and economics. The new M5S mayor of Rome has already made a disastrous start, struggling over administrative hurdles due to her inexperience. Faced with economic challenges or a renewed banking crisis, an M5S government hence seems unlikely to come up with timely and adequate policy responses, especially as it has voiced strong opposition to previous public invention on this front. Its anti-austerity stance would also put it on a collision course with the European Commission and fiscal largess would aggravate concerns about the sustainability of the public debt burden. 6| 22 November 2016 www.danskeresearch.com Research Italy Italian GDP has by no means recovered to 2008 level PMIs signal continued modest Italian GDP growth Source: Eurostat, Danske Bank Markets Source: European Commission, Danske Bank Markets The declining trend in the unemployment rate has stopped Italy’s youth unemployment is still much higher than euro area’s Source: European Commission, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets Government budget has improved post crisis but still deficit Italy’s public debt may have peaked but at a very high level Source: Eurostat, European Commission Danske Bank Markets Source: European Commission, Danske Bank Markets Inflation and core inflation remain far from ECB’s 2% target Italy’s output gap has been larger than the euro area % points 0 -2 -2 -4 -4 -6 Jan 10 Jan 11 Jan 12 Euro Area 15 Source: Eurostat, Danske Bank Markets 7| 22 November 2016 % points Output gap 0 Jan 13 Jan 14 OECD Countries Jan 15 Jan 16 United States Source: OECD, Danske Bank Markets www.danskeresearch.com Italy -6 Jan 17 Research Italy Private consumption has also lagged behind Consumer confidence has weakened this year Source: Eurostat, Danske Bank Markets Source: Fitch, Moody’s, S&P, Danske Bank Markets Almost no growth in Italian investments Industrial production has also struggled to recover Source: Eurostat, Danske Bank Markets Source: Fitch, Moody’s, S&P, Danske Bank Markets Industrial confidence around its historical means Still high business and consumer confidence Source: European Commission, Danske Bank Markets Source: European Commission, Danske Bank Markets Current account surplus close to euro area Low exports share of GDP in Italy Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets 8| 22 November 2016 www.danskeresearch.com Research Italy Nominal unit labour costs rose faster than in euro area Productivity lags behind the euro area Source: Eurostat, Danske Bank Markets Source: European Commission, Danske Bank Markets Population is projected to decline in line with euro area Italian employment growth weak compared with euro area Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets Housing prices have not bottomed out in Italy yet Construction permits very, very low Source: Eurostat, Danske Bank Markets Source: Macrobond Financial, Danske Bank Markets Higher yields recently but still low in a longer term perspective Low Italian debt ratings from all three agencies Source: Macrobond Financial, Danske Bank Markets Source: Fitch, Moody’s, Standard & Poor’s, Danske Bank Markets 9| 22 November 2016 www.danskeresearch.com Research Italy Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). 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