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Market reaction to Italian Referendum

8 December 2016 by Eoin Walsh

Now that the dust is beginning to settle after the Austrian election and Italian referendum last weekend, the reaction by the market so far certainly warrants a comment.  To recap on the results, in Austria, the far-right candidate, Hofer, was defeated by the independent left-wing candidate, Van der Bellen, while in Italy, the constitutional referendum seeking to reform the powers of the parliament, was overwhelmingly rejected, by a margin of almost 60:40.

While the Italian referendum result was expected, the margin of victory was certainly a surprise. This has naturally led to the main antagonists, the Five Star Movement party, calling for prime minister Renzi to resign and for an early election. Beppe Grillo, the Five Star leader, has predictably claimed credit for the result and with his anti-EU rhetoric views this as an opportunity to gain political capital while the angst of the electorate is clearly against the ruling political classes, and adds to the potential stress across the Euro-system. As such, one could have expected a negative reaction by the market.

So four days later, how are the markets reacting?

Starting with Italian equities, the benchmark FTSE MIB index initially opened down, over 2%, from its Friday close, before ultimately finishing flat following a volatile day.  However, it has since then rallied to over 5.5% higher than Friday’s close. Looking at individual names from the troubled banking sector, Intesa, probably Italy’s strongest bank, was almost 5% lower early on Monday morning but is now almost 10% above its Friday close; while Monte Dei Paschi Siena, the bank most in danger of collapse, is now 7% higher, after initially being 8% down on Monday.  Given that just this morning, the Italian Treasury had to deny reports that it was preparing to request a €15bn rescue from the European Stability Mechanism, while any plans to save the repair the estimated €350bn Non Performing Loan problem, must also be currently shelved, equity investors obviously see cause for optimism.

In credit markets, the safe haven, risk-free, US government bonds were also volatile, with the 10yr finishing flat on Monday, following a 1pt intraday move, however this is obviously influenced by US politics and not just events here in Europe. Closer to home, the XOVER index of the 75 most actively traded Euro HY bonds, which you would have expected to be a good barometer for nervousness in the credit markets, following a weak opening on Monday, when it briefly reached a wide level of 342bps, has tightened impressively since then to reach 312bps this morning; the tightest print seen for the current series.  This mirrors what we are seeing in cash markets as well, with bonds generally squeezing tighter in all sectors with subordinated bank names reaching high levels last seen almost 12 months ago.

So what is behind the strong rally despite the negative Italian result?  Undoubtedly, investors have learned from other specific-point-in-time events during the year, such as the UK referendum and the US elections, and were obviously well placed for a ‘No’ result and had money to put to work in case of a sell-off in the markets.  It also seems that “the street” may have been caught short and traders will obviously be keen to close out any short positions before year-end, especially as Draghi is also expected to deliver an extension to the QE program.  In addition, while there are very important European elections on the horizon for 2017, they are far enough in the distance to be discounted at the moment and following the Italian election, the path is now clear for a year-end rally.

Our more bearish readers could be forgiven for scratching their heads at the market reaction, as there is no doubt that populist, anti-establishment rhetoric is continuing to gain support, and the Eurozone project must surely be weaker – certainly, if Beppe Grillo and his Five Star Movement gains a foothold, it would not be a positive.

However, despite the many factors that can fuel bearish sentiment, markets do not move in a straight line and after a tough year, this rally will be very welcome to many investors before they waive a happy Good-Bye to 2016.

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