Weekly Market Focus

Hedging the Italian Referendum

Johan Jooste
Chief Investment Officer
Bank of Singapore
Member of OCBC Wealth Panel

After Brexit and Trump, political risk will now return back to Europe. For the next 6 months, Europe faces a very busy calendar of political risk events, starting with the Italian referendum on constitutional reform on 4th December 2016, the Dutch general elections on 15 March 2017, and culminating with the French presidential elections on 23 April 2017.

But the immediate concern is the Italian referendum. This referendum is not a vote on whether Italy stays or leaves the European Union (EU). Instead it is a vote on Italy’s constitution. A “yes” vote would streamline Italy’s inefficient and cumbersome policy-making process by essentially concentrating power in the Lower House. It is also widely seen as a vote of confidence for Prime Minister Matteo Renzi.

Chances of an Italian exit still small

The polls show that the “No” vote to Renzi’s reforms is more likely. Our base case is a “No” vote but a manageable outcome. With polls suggesting that “No” as the more plausible, the consequence would be the much needed reform in Italy would stall, bringing about increased political uncertainty. PM Renzi has said that he would resign and while there are calls for an early election, we believe this would be less likely due to a hung parliament. Instead, a transitional government is more probable, perhaps headed by Renzi or another technocrat, to set up new electoral rules which could take a year or more, implying the earliest elections in late 2017 or 2018 when elections have already been scheduled. Article 75 of the Italian constitution forbids a referendum on international treaties such as the EU membership or the euro hence the chances of an Italian exit of the EU is still small, for now.

Market implications under such a scenario would be as follows:

  • The stock price of Italian banks could face downward pressures as anticipated reforms surrounding the high levels of non-performing loans (NPLs) get stalled.
  • Similarly, the equity rally of European banks could be halted.

Markets are starting to grapple with the possibility that Renzi might lose this vote. Italian 10-year government bond yields are currently at their highest since early 2012, around half a percentage point above their Spanish counterparts with less than two weeks to go before the vote. However, if Renzi loses on 4th December, Italian government bond yields could edge even higher but there will likely be little contagion risk to the other peripheral economies, as markets rationalize that this event is largely an Italian issue with little EU exit risk. Market volatility may rise but subside subsequently. European cocos should still remain resilient under this scenario, but may present selective buying opportunities.

Limited upside but large downside

Our view is that Italian and European financials face an asymmetrical risk – limited upside but large downside - with the impending Italian referendum on 4th December.

As how we witnessed in Brexit and US elections, making big directional bets on the political outcome in Italy is often difficult. The better way is to hedge away possible downside risk through the buying of equity put options on European financials, particularly Italian banks.

Investors should also consider setting longer-term strategic hedges - such as more than 6 months - that protect against the important European political events like the Dutch and French elections for 2017.

Our investment views for the week:

  • Contrary to expectations, Donald Trump has been elected the 45th president of the US. Perhaps more surprisingly, the markets remained relatively calm after the initial knee-jerk sell-off, especially in Asian markets.
  • Nevertheless, we expect volatility to remain elevated given the uncertainty for the financial markets as to what a Trump presidency really represents. Trump’s desire and ability to implement his economic policies remains unclear.
  • Also, ahead of the busy political agenda, European political risks loom. Coupled with the extended valuations, risk-reward remains asymmetrical for investors. Accordingly, we maintain our Underweight stance on equities.
  • Regionally, we continue to be underweight the Developed Markets (DM) of the US, Japan and Europe. Meanwhile, in anticipation of greater uncertainty for the region, primarily in view of Trump’s stance on trade, we are lowering Asia Ex-Japan from neutral to Underweight.
  • Sector-wise, domestically driven names are likely to hold up relatively better in the near-term. In particular, we like Healthcare.
  • It is imperative for investors to remain calm and keep a longer-term perspective, with a balanced and diversified portfolio of high quality stocks and bonds. In this way, the new president is unlikely to have a dramatic effect on investments.