29 novembre 2016

Ahead of Italy’s Referendum: Political Risk and Financial Fragility

Since the beginning of this year, the performance of Italian financial assets has spectacularly disappointed. Domestically oriented small-cap stocks (YTD: -21.5%) have underperformed their global (YTD: +13.2%) and European peers (YTD: -3.7%) by a wide margin (see Figure 1). In addition, on the bond market, the spread between Italian and purportedly safe German sovereign bonds has considerably widened (see Figure 2). Hence, there is little doubt that the effect is primarily due to country-specific idiosyncratic forces. How so?

Earlier this year, Italy’s Prime Minister Matteo Renzi announced a referendum on his principal reform proposal, a constitutional change that seeks to simplify the country’s governance. However, recent polls indicate Renzi lacks the necessary majority. For the electorate, poorly informed and disgruntled by economic woes, seems to look for a way to punish the head of government. Observers thus reckon that Renzi would need to resign and pave the way for re-elections, if the referendum fails.

What makes Italian political risk particularly problematic is that Italian banks currently undergo major restructurings. Thus, different from Brexit or the US presidential election, political uncertainty such as a failing government could immediately undermine efforts to stabilize the banking sector. In a worst-case scenario, investors would abstain from the banks’ recapitalization efforts altogether in response to heightened political uncertainty. This may force some ailing institutions into bankruptcy or to demand state aid. But Italy’s economy seems ill-equipped to handle a wave of bank failures that may cripple the country’s already dim near-term growth prospects. The risk of a chain reactions appears real.

Investors seem to pay close attention to the intimate connection between Italy’s sovereign and bank-related default risks. The 5-year sovereign CDS has almost moved in lockstep with those of the country’s two largest publicly traded banks, Unicredit and Intesa Sanpaolo (see Figures 3 and 4). Moreover, the sovereign CDS has recently risen more than two standard deviations above its 250-day moving average for the third time in less than a year. Clearly, investors are nervous.

By contrast, the fallout on other European sovereigns remains somewhat limited so far. Despite a pick-up in sovereign risk, the Italian level of stress was consistently higher than for other major Euro area sovereigns such as France or Spain (see Figure 4). Economic fundamentals still seem to be properly priced. For example, the Italian debt burden is not only more expensive on average (3.4% vs. 2.6%) but also has a shorter duration (6.7 vs. 7.4 years) than France’s.

In a nutshell, one week ahead of the Italian referendum investors seem to be wary of Italian political uncertainty on fears that urgently needed bank recapitalizations may be delayed. As a result, sovereign and bank default risk are closely intertwined. The renewed systemic stress in the euro zone could put pressure on the ECB to prolong its Quantitative Easing Program in its next monetary policing which will be held on 8th December 2016, so four days only after the Italian Constitutional Referendum (see the Ballot Paper in figure 7). The political vulnerability of the euro zone edifice could eventually trigger an even deeper depreciation of the EUR/USD as anticipated by Riskelia’s Radar on G10 currencies (figure 8).

Figure 1: Small Cap Equity Indices for the World, Europe and Italy:

Figure 2: Yield Spread between Italian and German 10-Yr (left) and 2-Yr (right) Government Bonds

Figure 3: Standardized 5-Yr CDS Spreads for Italy and Three Selected Banks:

Figure 4: 5-Yr CDS Spreads for Italy and the country’s two biggest banks (Unicredit and Intesa Sanpaolo):

Figure 5: Standardized 5-Yr CDS Spreads by Country:

Figure 6: Structure of Italian Government Debt.

Figure 6: Structure of French Government Debt.

Figure 7: Italian Referendum Ballot Paper.

Figure 8: Riskelia’s Radar on G10 Currencies.