“One or two months ago this referendum was thought of a a ‘make or break’ for Europe. If you look at the bond spread and the equity markets now, it looks like it has been reduced to an Italian problem,” says David Karni, head of fund selection at BCC Risparmio & Previdenza in Milan. Those who said the Italian referendum would be a ‘bigger threat than Brexit’ just a few months ago have indeed been remarkably silent in recent days.
Fact is that Italy’s problems have yet to spill to neighbouring countries. So far, only Italian assets have taken a hit. Italian 10-year bond yields have doubled in just three months, with the spread versus the Bund widening to more than 160 basis points. Italian stocks are down by about 17% year-to-date compared to the MSCI Europe trading broadly flat. Italian bank stocks, which still represent about a quarter of the index, even have lost almost half of their value this year.
While Italian stocks could of course go down a lot more, they have already lost significant ground, even though the Italian economy has held up reasonably well this year. But the rejection of reform-minded PM Renzi by the Italian electorate means Italy “will live in a political limbo for at least one year until new elections will be announced,” says Alessandro Viviani, a fund analyst at Old Mutual Wealth in Milan. “In the meantime all the reforms Italy urgently needs, most importantly the recapitalisation of the banking system, risk to be stalled. We will be monitoring the situation day by day before reducing further our direct exposure to Italian bonds and risky assets like European equity.”
It indeed seems that all the risks in Italy are now to the downside, especially if one realises that the country’s ailing banking sector can only really be saved if the economy starts growing faster again. The absence of further reforms combined with the unsustainable situation of Italy’s economy (high debt and unemployment and low growth) could lead to downgrades by rating agencies, fears Viviani.
Italy’s credit rating is another source of concern. According to Viviani, it is a distinct possibility that credit rating agency S&P will downgrade Italy’s debt to junk, as happened to Portugal in 2011. The country now has a BBB- rating, the lowest possible investment-grade rating. Such a move would put further pressure Italy’s already embattled banks, which would see funding costs increase and their government bond portfolios losing value.