However, the Italian ‘no’ vote is another thorn in the side of eurozone progress, but an imminent general election is unlikely.
Few parties other than the anti-establishment Five Star Movement (MS5) also have an incentive to go to the polls. An election may follow if the interim government struggles to pass the ‘Italicum’ election reform agreed last year. Even if the worst happened and the MS5 did gain enough power to call a referendum on European Union membership (this would need a law change first), there is not nearly the same level of discontent towards the EU than there is in the UK.
Eurobarometer survey
The European Commission’s Eurobarometer survey was one of the few that suggested the UK might leave. This survey suggests that most Italians view the EU positively, and are overwhelmingly in favour of the single currency, the single market and a common immigration policy.
As such, the sovereign bond market’s muted reaction immediately following the electoral reform referendum was right, and similarly, borrowing costs for the eurozone banking sector have also remained unmoved. Credit default swaps (CDS) – default insurance that measures a bond’s credit quality – on the iTraxx Europe senior and subordinated financial index are trading only a few basis points wider.
Yet the planned recapitalisation of Banca Monte dei Paschi di Siena and seven other medium and small banks are now likely to be extremely difficult, especially if there is prolonged policy uncertainty from the tortuous formation of a new government. This increases the chance of recession on the brink of which Italy is already teetering. The fallout from the eurozone debt crisis still drags on and the fix has edged further away.
Meanwhile, equity valuations in the eurozone are not cheap compared with their long-term average or the historical ratio against other regions. Notably, returns on equity are unlikely to improve without a recovery in the still-fragile financial sector.
Earnings momentum is weak and analysts have set a high bar for 2017: earnings per share growth of more than 13 per cent.
Political and equity risks
Given the political risks over the next year, it is difficult to envisage the equity risk premium moving much lower or valuations moving much higher. This means slim protection against any potential negative revisions to 2017 earnings.
Meanwhile. closer to home, Brexit negotiations will lumber on, but in contrast to the US and Europe, investors have started to penalise UK-focused stocks quite conspicuously in terms of near-term profit projections and equity risk premia.
There is limited potential for political loggerheads in Europe and Brexit to send the economic cycle into a tailspin this year, so we feel that capital should remain invested, but that does not mean that stock prices will not fall if events make the policy outlook more uncertain.
