Italy’s referendum will not weaken the European project as much as critics hope, and Trump could help equities, says Will Railton
"The vote looks to me to be more about the euro than constitutional change”, tweeted Nigel Farage shortly after the Italian polls closed on Sunday night. Eurosceptics are heralding the resounding result (a 59.1 per cent share for No) as essentially a rejection of Italy’s membership of the single currency – the next chapter in a saga which has seen the UK vote for Brexit and Americans choose Donald Trump as their next President, and which will conclude with the dismantling of the European Union.
Others are not so convinced. Despite the resignation of Matteo Renzi, Italy’s centre-left Prime Minister who had pinned his career on a Yes vote which would have given the lower chamber of the Italian parliament the executive powers he said were necessary to push through economic reforms, it is unlikely that a snap election will be called.
This is because of an electoral law, known as “Italicum”, which was passed last year and would ensure that, in Italian elections scheduled for 2018, a single party could gain a majority of seats in the lower chamber of the Italian parliament without needing to win a majority of votes. In the current political climate, no party in Italy’s ruling coalition would call for an election which might be won by either the Northern League or the Five Star Movement – eurosceptic parties which are both polling well in Italy.
Instead, the Italian president, Sergio Mattarella, is likely to give a mandate to Senate president Piero Graso or economics minister Pier Carlo Padoan to form a caretaker government. Under their premiership, Italicum would probably be amended – it was intended to accompany the impeded constitutional reforms – and Italy’s troubled banks will continue their efforts to recapitalise by attracting private investment.
Markets met the news of the No vote with relative calm. The euro yesterday pared back its initial losses, while yields on Italian and German government bonds widened by little more than 0.01 per cent – far more slowly than in the weeks before the referendum, suggesting that investors were satisfied that the risk had been priced in. Italian equities rallied during yesterday’s trading.
“Risk remains limited to Italy and is far from being systemic. And the scenario of Italy quitting the Eurozone has been ruled out: we see no signs of contagion, not even in Spain,” wrote Eliezer Ben Zimra, fund manager in asset allocation and sovereign debt at Edmond de Rothschild Asset Management. This is a confident prediction, but there is little evidence that a vote for No correlates in any way with a vote to leave the single currency. A poll published in La Stampa, an Italian newspaper, two weeks before the referendum found little appetite to abandon the euro among Italians. Fully 67.4 per cent supported staying in the currency union.
Beyond political risk
What does this mean for investors? Political risk has been the story of 2016, and will strongly influence market movements next year. But Europe, including the UK, contains 19 per cent of the world’s listed companies. With many calling time on the 30-year bull market in bonds, and inflation expected to rise considerably next year, to ignore continental firms would be to ignore some stocks with great potential.
Investment in European equity markets has been dictated to some extent by ultra-loose monetary policy, as has been the case in other rich-world markets. A desire for low-volatility stocks which pay dividends has pushed capital into consumer staples, utilities and other so-called bond proxies, pushing up their valuations. This trend may continue, given that the ECB is widely expected to announce at its meeting on Thursday that it will extend its QE programme for another six months beyond the current end date of March 2017.
Stocks to rely on
Europe is home to many serious global companies which rely on more than the continent’s (admittedly) weak growth and whatever the ECB does. And the continent is also a crucible for some exciting growth opportunities.
Tim Crockford, European equities portfolio manager at Hermes Investment Management, picked out a number of mid-sized, undervalued firms creating platforms for strong cash generation in the future. French video game publisher Ubisoft has moved away from one-off product launches to add new levels and downloads to its existing products as a means of earning more from every game it releases. The company is also seeking to expand its presence in competitive gaming, also known as E-sports, which is attracting increasing attention from sponsors and advertisers.
Crockford has also added the German mobile communications services provider Freenet to his portfolio. Market sentiment has soured on it after a host of recent acquisitions which Crockford thinks will prove valuable in the future, including a signal provider which will give it a monopoly over German terrestrial TV signal. Tech and healthcare, he noted have become fertile ground for mergers and acquisitions, with borrowing so cheap.
Another approach might be to choose funds whose manager’s style may help to shield them from political uncertainty. Darius McDermott, managing director of Chelsea Financial Services recommends the Mirabaud Equities Europe ex-UK small and Mid-cap fund, whose manager “ignores European politics (apt in this situation) and most economic factors, and focuses on individual companies to find Europe’s hidden gems. The fund is designed to be pragmatic and adaptable. Key to the team’s success is an intensive and targeted road-trip programme to meet as many companies as possible.”
He also points to Henderson European Focus, which seeks to identify industry or sector themes which will still be around a decade from now. “This allows the manager to ignore the macro-driven fear and optimism that consumes other investors, and focus on what matters – real or ‘absolute’ value,” says McDermott.
Trump and Europe
Even the political upheaval of 2016 may not be as catastrophic for European equities as it might first seem. UBS has suggested that Trump’s anticipated boost to growth and inflation in the US could benefit European shares more than American ones. Mining and construction are 10 times more important to European earnings, wrote macro strategists in a research note yesterday. As the commodities price freefall ends, continental companies could be poised to benefit. Moreover, inflation is likely to help financials and energy, which pay more than a third of European dividends.
But what if resentment of the EU continues to harden? The Centre for Economic and Business Research puts the chances of Italy remaining a Eurozone member in five years’ time at 30 per cent. And few would write off Marine Le Pen’s chances in next year’s presidential election in France.
But after investors were taken by surprise by Brexit and Trump, it would be equally wrong to assume the worst-case scenario from any future political shock facing Europe. Doing so could mean missing out on some good opportunities.