Italian Referendum Fails, Stocks Smile

Time and again in 2016, pundits warned major political events would cause an earthquake for markets. Brexit. Donald Trump winning the US election. And now Italy's Senate reform referendum, which failed Sunday, taking Prime Minister Matteo Renzi down with it. Yet each time, after the widely feared thing actually happened, stocks were fine. Sometimes within a couple days, as with Brexit, and sometimes within a couple minutes, as with Italy, giving investors another chance to learn a crucial lesson: Don't overrate political events.

Markets are efficient and very, very good at discounting widely discussed events before they happen. Such was the case with Italy's referendum. Unlike Brexit and the US election, referendum polls pretty soundly signaled the referendum's defeat weeks beforehand. Conversation has long since moved from, "Will it pass or fail?" to, "What happens after it fails?" Even the related "if" over whether Renzi would stay in power seemed mostly resolved before the vote. After flip-flopping on whether the vote was also a referendum on his leadership (first he said it was, then-after seeing David Cameron go down post-Brexit vote-walked it back), in the campaign's final days, Renzi made it pretty clear he'd go if he lost. Hence markets weren't shocked when, after 60% of voters rejected the ballot measure, Renzi announced his intent to mozie over to President Sergio Mattarella's office and hand in his papers.

Italian stocks dipped as much as -2.1% intraday Monday, but by day's end they'd clawed most of it back, and the benchmark FTSE MIB closed just -0.2% down on the day. Most everywhere else, markets were buoyant. The UK's FTSE 100, Germany's DAX and France's CAC 40 all topped 1% (in local currencies), enjoying pleasant mornings. The S&P 500 was up all day, finishing 0.6% higher.^[i] Finance blogger (and CNBC pundit) Josh Brown-aka "The Reformed Broker"-sums the reaction up as "crisis fatigue. If everything is a crisis, then nothing is." Calling it "the boy who cried wolf" would be a bad analogy, so we won't do it, but you get the drift: When people repeatedly hear events are certain negatives for stocks, and reality proves the warnings wrong, at some point, people get wise and start brushing them off.^[ii]

As for what comes next, Italy will get its eighth government since 2000 and 64^th since Il Duce. No one knows who will lead yet, but we'll gain clarity in the coming days as Mattarella meets with party leaders and decides whether to call snap elections, instruct Renzi's Democratic Party (DP) to form a new administration or appoint a technocratic government. Of those options, the first seems least likely, considering Mattarella is a staunch europhile and the anti-establishment Five Star Movement (M5S) seems poised to do well in a snap vote. Most expect Italy to get a technocratic government with a narrow mandate to focus on electoral law reform that would limit the possibility of a hung parliament. For now, though, Renzi will stay in power (at Mattarella's request) until Parliament approves the next budget.

In other words, Italy likely maintains the status quo: A gridlocked government that can't push through labor market or other long-delayed reforms, but can't do any harm either. It would also keep pro-euro leaders in power until 2018 at least, limiting populism's march. M5S may be polling neck and neck with the DP now, but a lot can change in a year and a half, especially if M5S-led local governments continue floundering. It's fair to point out that in Italy, "status quo" means economic and political basketcase, but again, markets are efficient. By most measures, Italy is in a far better place than in 2011 and 2012, when the eurozone crisis threatened to take it down. If global markets could handle Italy then-when Silvio Berlusconi was a going concern, the economy was shrinking and debt service costs were spiraling-they can handle Italy now. For all the hand-wringing, its economy is growing, and low interest rates have pulled down borrowing costs.

We think Italy's referendum is most compelling when viewed in concert with Austria's presidential revote, which also occurred Sunday, pitting the former leader of the Green Party Alexander Van der Bellen against the Freedom Party's Norbert Hofer. Both are technically populists, as the establishment candidates both fell in the first round earlier this year. But Van der Bellen is regarded as a pro-euro statesman, while the anti-EU Hofer would have been Europe's first democratically elected far-right head of state since the 1940s. In May, Van der Bellen narrowly won, but Hofer challenged, and the courts ruled there were irregularities and overturned the results. This time around, polls had Van der Bellen ahead 51% to 49%, but he won 53% to 47%-a stronger showing and rebuke to all those fears of a post-Brexit domino effect.

Remember this next year, as the Netherlands, France and Germany go to the polls with anti-euro populists polling well. Populism doesn't beget populism, and pro-euro parties are more resilient than they usually get credit for. French voters just said "non, merci" to former President Nicolas Sarkozy in his party's presidential primary, rejecting his populist turn in favor of free-market reformer FranÇois Fillon-a former Prime Minister who is about as "establishment" as it gets. Spain's pro-euro government just returned to power after two elections and 10 months of deadlock, sidelining the populist Podemos party. Angela Merkel is running for a fourth term in Germany and presently has no clear rival (though that could change as the other parties get more organized). Fears of populism splintering the eurozone are just another iteration of euro breakup fears, which markets have dealt with ad infinitum since 2010.