Italians awoke to a familiar sight Monday morning, the resignation of yet another prime minister and the potential collapse of yet another government. Prime Minister Matteo Renzi offered his resignation following the rejection of a referendum he pushed which would have reformed Italy's near 70-year-old constitution. The referendum was aimed at decreasing the power of the upper-house of government thereby allowing for reforms to more quickly be adopted. What had started out as a referendum on constitutional changes had morphed into a vote of confidence for the prime minister and of the eurozone. The Italian people rejected both.
The significance of the Italian election is twofold. Not only was their record voter turnout (over 70 percent) and the referendum rejected by a landslide (60 percent of the voters,) but exit polls revealed uneasiness among Italians with the trajectory of the economy. In last week's column I detailed how there were nearly half-a-trillion dollars in non-performing loans outstanding in the Italian banking system. Many originated following the 2008 Great Recession and have yet to be written-off. Reform of the banking system is critical for the Italians at this point and Renzi thought he could convince the Italian people as much.
The sentiment among many Italians, according to exit polls, is one of frustration. The use of the euro obviously strips Italians of monetary policy tools and the strength of the euro, albeit weak against the U.S. dollar, has made its domestic goods very expensive. This is bad news for a historically important manufacturing powerhouse. Cars and trucks made in Italy are much more expensive than the Italians would want and local textile production has diminished every year since the adoption of the euro 16 years ago.
Financial markets punished Italians for their rejection of the referendum with the benchmark FTSEMIB index down over 1 percent bringing its yearly return to -21 percent. Another perhaps more important indicator, the price of insuring Italian debt, or credit-default swaps, jumped by over 6 percent to 1.74 percent. Markets view Italian debt as more risky now and to stem this perception of panic, early indicators out of Italy are that the president will not call for snap elections but rather ask other parties to form a government or merely find a new prime minister to lead the country. This, of course, will be a very temporary solution to a systemic problem. Italy's saving grace, however, is a very pro-active European Central Bank that will do whatever it takes to prevent another Grexit scenario. Following the successful Brexit vote, the ECB has made it clear that it will do whatever it takes to protect the eurozone. Such resolve is exactly what investors value and as such, for the short term, crisis has been averted.
Perhaps more meaningful for European leaders, was news out of Austria of a rejection of the ultra-nationalist presidential candidate Norbert Hofer and election of Alexander Van der Bellen, an ardent pro-European candidate. Following the Brexit vote and the victory of Donald Trump in the United States, many had predicted that a new wave of nationalism and ethnicism would sweep over Europe. Had Hofer won, ultra-nationalist Marian Le Pen in France and the far-right in the Netherlands were expected to win their elections next year. This would have been the beginning of the end for the European Union and the eurozone. The Austrian vote gave hope to those that expected a win for the Italian prime minister, but it was not to be.
The next step for the eurozone is helping ailing economies like Italy, Portugal and Spain clean bad-debt from their banks' balance sheets and recapitalize their banking sectors. Short of immediate intervention, these economies will follow their Mediterranean cousin, Greece, into a tailspin of economic sorrow.
The U.S. dollar has taken a breather against global currencies in its one-month rally as investors are no longer sure what the Federal Reserve (Fed) will do in the coming months. While a rate increase is still seen as very likely at the next Fed meeting next week, some new data has raised questions in investors' minds as to whether it will keep increasing rates or not. While unemployment dipped to a nine-year low of 4.6 percent, wages actually shrunk for the month. Also the unemployment rate decreased as more people dropped out of the job market, bringing the participation rate lower as well.
All eyes will be on Fed next week as it will surely move European and global markets.
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