Since my previous weekly comment (Brexit – Aftershock or Not? – 3rd August 2016) – then some six weeks after the initial shockwaves had hit global markets after the UK’s vote in favour of ‘BREXIT’ – things have indeed moved on, and not in a particularly positive manner for the Eurozone (as we currently know it!).
During last weekend, the Italian electorate went to the polls to vote ‘NO’ in Italy’s referendum, thereby blocking the possibility of any political and economic reform within the country and triggering the near-immediate resignation of the now former reform-minded Prime Minister Matteo Renzi. Though the cracks have yet to appear, our view is that the ultimate consequence of this vote will likely leave little option but for Italy to quit the single market. Rather like the pivotal scene in the movie Force 10 from Navarone*, this, in combination with BREXIT is the small explosion inside the dam wall which will ultimately lead to cracks appearing on the outside and, in the end, the collapse of the structure holding the EU together.
In the meantime, the potential ramifications surrounding this ‘NO’ vote in the more immediate future are not insignificant. The Italian economy, as we know, is relatively fragile and among the many manifestations of that fragility is the issue of the poor state of the country’s banks. According to Nick Andrews and Tom Holland of Gavekal Research:-
“The Italian banks need to raise an estimated €40bn in new capital to rebuild their balance sheets. That sum is small, relative to Italy’s €1.76trn economy, but given the Italian banking sector’s record of capital destruction, there is a negligible chance that the market will advance the necessary funds in the absence of the sort of wholesale restructuring program that yesterday’s ‘No’ vote makes politically impossible. That leaves Rome with few choices. Nationalisation of the weakest banks, notably Banca Monte dei Paschi di Siena, Italy’s fourth largest private sector bank by assets, would be one possibility. However, under European Union banking rules which came into force this year, that would require a bail-in of creditors, which include many retail bond-holders. Not only would that be unpalatable politically, but it would also further undermine confidence in Italy’s other banks, making market-led recapitalisations even less feasible.”
Unfortunately, given that the prevailing extremely low/negative interest rates across the Eurozone are likely to remain in place for the foreseeable future, any possibility of self-help for the banks falls somewhere between slim and none (low rates compress the margin between what banks pay to borrow and what they earn in interest on loans. That margin is how they make money).
Interestingly, it would appear that markets are not fazed by this long-term scenario: in fact, the Italian Equity Index is up over 5% since the vote, trading at a 6-month high, whilst most bank Credit Default Swaps are lower. From this, we can only conclude that markets are focusing on the VERY short term and the expectation of, at the very least, another special dose of medicine (as in further monetary stimulus) this Thursday from ‘Super’ Mario Draghi. This will most likely take the form of extending the ECB’s asset purchase programme (currently running at €80 billion per month) beyond next March, which is meant to increase lending, growth and inflation.
In conclusion, time will tell whether or not ‘BREXIT’ was the first crack in the dam. Fortunately, or not, we don’t have to wait too long to find out, with a number of other significant votes taking place across the Eurozone over the next 12 months.
*A second rate sequel to the classic “Guns of Navarone” which, for the trivia fans among you was Robert Shaw’s last film, parts of which were shot on the “other” Channel Island of Jersey.A Crack in the Eurozone Dam?