Italian referendum and global markets: What’s next in 2017

‘Once more unto the breach’. We imagine financial markets feel similar to the troops in Shakespeare’s King Henry the Fifth, after the no vote in the Italian referendum on constitutional reform.

Political events and the markets: The dangers of overreacting

In a year full of political upsets, markets have to once more overcome uncertainty. With a 59.1% to 40.9% margin against the proposed constitutional and political reforms, according to Bloomberg as of 8.00am GMT today, Italy’s Prime Minister Renzi suffered a defeat that cost him his job. However, beyond short-term volatility, we don’t see this potential setback for the Renzi government as a game changer for our market outlook and upcoming 2017 Global Market Outlook – Annual Report, to be released on Dec. 6 here.

The outcome of the referendum is clearly a concern for the European Union (EU), both politically as well as in terms of its impact on financial markets. On the political front, we have to see whether Renzi does actually resign. And if he does, will Italy’s President Sergio Mattarella call for new elections or opt for a caretaker government? I continue to believe it is unlikely that new elections will be held.

The president is keenly aware it will probably not resolve anything and would create a lot of unwanted uncertainty. I believe a continuation of the current government under Renzi or his Minister of Finance, Pier Carlo Padoan, is the most likely outcome.

Under those circumstances, we expect markets to overcome their negative reaction relatively quickly. After all, nothing much has changed and, in the absence of a political crisis, we believe it will quickly be business as usual.

The concern that this no vote will push Italian government bonds and bank shares into a self-reinforcing downward spiral is not likely to materialize. The European Central Bank’s backstop through its quantitative easing program is too powerful. And a bank recapitalization effort will likely gain momentum should stress levels rise.

That being said, the outcome of the referendum is a potential setback for the EU, as it strengthens the country’s populist-oriented political parties, which question Italy’s inclusion in the European Monetary Union and/or use of the euro as its currency.

Still, we believe it is important to not overreact to political events. Two political examples of investors having an abrupt over-reaction to political headlines where the markets soon course-corrected are quite recent. For example, we saw that while markets reacted swiftly and negatively to the Brexit vote, they soon recovered. And later, while many expected equity markets to react negatively to the 2016 U.S. presidential election’s outcome, equity markets actually experienced a Trump bump as the S&P® 500 Index ended up 3.4% for the month of November.

So, where does that leave us, as we look toward 2017?

As we noted in our 2017 Global Market Outlook (being released Dec. 6), we anticipate a challenging investment environment in the new year.

Near-term, we expect global economic growth is likely to improve, spurred by fiscal stimulus as political leaders worldwide move away from austerity. Longer-term, however, our global team of investment strategists think the prospect of trade protectionism raised by Brexit and the U.S. presidential election could mean slower growth and higher inflation.

We’ll watch closely for evidence that markets have moved too far into fear or euphoria and look for downside protection when it is cheap.

In our 2017 Global Market Outlook report, titled, “The New Abnormal,” we explain why we believe the search for yield is not going to get any easier in 2017 against a backdrop of record U.S. equity prices, narrow credit spreads and low bond yields.

As our Global Chief Investment Officer Jeff Hussey says: "Investors will need to venture further afield in search of returns, using the full range of tools available in a globally diversified, multi-asset portfolio.”

To learn more about our investment strategists’ perspective for 2017, click here tomorrow .