Deutsche Bank: Italian Referendum May Leave Investors Scratching Their Heads

There are two potential market paths following Sunday’s Italian referendum vote, a Deutsche Bank research report notes. Either path is likely to generate market volatility, either upside or downside deviation. In particular, Italian bank stocks could be at the center of the action. But even if a surprise “Yes” vote was to occur, the much discussed Italian bank bailout isn’t a sure thing.

Italian referendum vote – The Italian banking sector has the most at stake in referendum

The most significant short-term downside risk to a “No” vote in the Italian referendum can be seen in the banking sector. As previously pointed out in ValueWalk, a “Yes” vote in the referendum clears the way to bailout Italian banks that have significant non-performing loans on their balance sheets and unknown derivatives exposures as well.

This isn’t the first time market analysts have recognized the banking issue, as the potential for a bailout of both Italian and certain German banks was a whisper conversation in favor of a Brexit.

Without the streamlined ability to grant a bailout with pesky interference from politicians who will likely channel populist anger on the topic of repeated bailouts without any apparent banker accountability.

Italian referendum vote – “No” vote could lead to government vacuum

In the case of a “No” vote, Senior Economist Marco Stringa and Strategist Simon Carter think Italian Prime Minister could leave, potentially creating a government vacuum at a time when the banking system could be in need of attention.

“Markets could react negatively, with the risk of particular stress on the Italian banking sector,” stated the November 28 report titled “Risks after and beyond Italy’s referendum.”

If a solution to the vacuum is not quickly found, stress could mount to levels above volatility levels seen over the early summer. Separate analysis points to eyes moving into a potential contagion impact, particularly if non-cleared derivatives are involved.

What might seem like a positive outcome – a prolonged muddle-through scenario where complacency and the status quo reigns – is Deutsche Bank’s medium term risk.

“We see a non-trivial risk that a new, prolonged period of ineffectual governments leads to systemic instability in the medium term, Stringa and Carter wrote. “A muddle-through scenario means a very low likelihood of significant reforms; in our view Italy’s economy will continue to perform poorly in both absolute and relative terms. We do not see this as a sustainable equilibrium.”

In this environment where little change occurs, “support for euro sceptic parties will likely grow” from their current level of 44% support in the polls.

Italian referendum vote – In case of a “Yes” vote, beaten down banks could rally

In the event of a “No” vote, downside volatility is expected. But the big volatility surprise could be to the upside.

“There could be room for a material rebound in Italian assets, driven by banks’ equity prices, in the case of a “Yes” victory,” the report said. A Yes vote would consolidate power, make bank bailouts an easier proposition and also serve to consolidate power, making populist movements increasingly difficult to control the government.

The jump in stock prices could come as Italy’s equity market has significantly underperformed world indexes in 2016. The FTSE MIB, Italy’s primary stock market index, was trading near 21,000 to enter 2016 and is currently scraping near the bottom end of a trading range at 16,562. Further, the underperformance of the banking sector has recently accelerated in anticipation of the December 4 vote.

Even with a “Yes” vote a bank bailout is not guaranteed

Even with a “Yes” vote, however, the bank bailout might not be as sure as is expected.

“We expect no immediate proactive systemic solution for the banking sector even if the Senate reform is approved,” the report said, noting that it might be “too pessimistic.”

The problems of the Italian banks go deep with little in the way of long-term solutions. ”A systemic solution to the banking sector could be a chance of turning the current growth-banks-politics vicious circle into a virtuous one and revitalize the reform process,” the report noted, echoing numerous bank analysts' thoughts.

But if a solution was found it would be a significant positive. “In the case a proactive systemic solution is implemented we would significantly revise upwards our GDP forecasts.”