The Italian people have voted to reject a package of democratic reform measures proposed by Prime Minister Mateo Renzi. Mr Renzi has resigned following the result, triggering a period of political uncertainty in the EU’s fourth largest economy. What does this mean for investors? In these talking points, we’ll review the situation and its effect on investment markets.
The Italian referendum and Austrian presidential election are the latest events in a year of unexpected results and political turmoil. The referendum result is likely to dominate news flow over the next few days and therefore we thought it would be useful to provide investors with our perspective on the impact of the vote, the outlook for markets and the response of our investment team.
Before considering the implications of the Italian vote, it is worth reviewing the facts of the referendum. This vote was intended to bring structural reform to the Italian political system and in doing so, facilitate economic policies designed to boost the growth of the Italian economy. While there appears little disagreement that reform is necessary in an economy that has shrunk over the last eight years, these reforms were opposed by the populist ‘Five Star Movement’ and the Northern League.
By threatening to resign in the event of a ‘no’ result, Prime Minister Renzi appeared to shift the focus of the vote from the proposed structural reforms towards a referendum on his leadership. The resounding success of the ‘no’ campaign has consequently led to the resignation of the Prime Minister and created a period of uncertainty in Italian politics.
Although the result appears to have had an immediate impact on capital markets with both the Euro and Asian equities falling in price, this reaction appears far more muted then following the Brexit vote or U.S. election results. There are likely to be three reasons for this:
The first is that instability has long been the hallmark of Italian politics, demonstrated by the parade of five Prime Ministers over the last decade. Consequently, this latest change in the political landscape represents ‘more of the same’ for a nation used to dealing with political change. Second, unlike the Brexit vote or Trump election, the Italian referendum represents a continuity of the existing situation rather than a significant change at this stage.
This continuity is even more apparent when one considers the fact that Renzi secured 40% of the vote despite being opposed by two populist parties ideologically opposed to each other. Third, and potentially a consequence of the previous points, market participants appear to be taking a more cautious approach to pricing in the impact of this vote, having been ‘whipsawed’ by market movements immediately following the last two events.
Turning to the longer-term impact of the result, it is noticeable that media coverage of the potential consequences of the ‘no’ vote is very light on detail but rich with suggestions of potential market turmoil and even a further banking crisis. This lack of detail should highlight the uncertainty that accompanies this result. In common with the previous political events of 2016, it is currently unclear what the longer term political outcome of this referendum will be and how this will impact capital markets and asset prices.
In this situation, the famous quotation of President Roosevelt appears particularly apt: “(the) only thing we have to fear is fear itself”. Fear is a natural but destructive trait in both investors and portfolio managers as it promotes action based on weak evidence.
Any changes to portfolios at this point would necessarily depend upon drawing a single conclusion from the broad range of potential outcomes that now present themselves. This approach is little better than selecting a single number on the roulette wheel and will likely lead to a similar result. We can claim no skill in forecasting political outcomes, a trait we appear to share with professional pollsters and political analysts, and therefore will not gamble with investors’ capital.
Instead, we will continue to prioritise research over reaction, carefully assessing the fair value of the potential investments and comparing that to the current price. As valuation-driven investors, we are drawn to those assets currently trading at a significant discount to their fair value in the expectation that this discount will close over the long term, creating above average returns for investors.
One of the most interesting areas we are currently investigating is European financial companies, primarily banks and insurance companies. We have recently undertaken a substantial research project in this area and concluded that despite the challenges posed by the current economic and regulatory environment, banks were significantly undervalued and represented an attractive opportunity for investment.
This is especially relevant in the context of the Italian referendum as one of the key concerns to emerge from a ‘no’ vote is the challenge that it poses to the re-capitalisation of the Italian banks which form 18% of the Italian stock market and are currently struggling with bad debts. We can therefore expect additional volatility in the price of Italian bank shares in the near term.
In this context, volatility in market prices should be welcomed, as a fall in prices can create opportunities to buy assets that are significantly under-priced relative to their long term fair values, thereby sowing the seeds of future returns.
Our ability to access these opportunities is dependent upon having sufficient cash available in portfolios to fund these purchases. Our portfolio managers have therefore been using the high prices we have witnessed over the last year to raise cash holdings by selling positions that have become over-priced. Consequently, portfolios are well positioned to make new purchases where we see opportunities.
We also remain in close contact with the managers who run the underlying funds in your portfolio. Each of these managers has been carefully chosen for their experience, expertise and rigorous investment process. We therefore expect them to approach the current situation with a similar long-term, opportunity seeking mind-set.
We appreciate that the current period is unsettling for our investors and we hope the above provides a useful summary of the work we are undertaking on your behalf. We will continue to do our utmost to keep you and your adviser informed of our latest thinking and will of course update your adviser of any changes that we make to your portfolio. You may also find the Morningstar.co.uk website useful as it provides extensive financial news coverage, detailed analysis and investor education resources.
Should you have any questions or require further information in the meantime, please do not hesitate to contact your adviser.
