Europe extends stimulus after Italy votes ‘no’

Plenty of talk in the lead up to the Italian referendum on Sunday was about what prime minister Matteo Renzi would do if he lost (resign) and what this might mean for the future of the eurozone (complications). Very little was about what steps Europe would take next.

I wrote about the politics behind the referendum a couple of months ago, with some background around what Renzi was hoping to accomplish and why this could have been a good thing for the Italian economy.

However, that ship has sailed now and, as with our own ever-pending Article 50 invocation, the Italians had better just get on with it and decide where they will go from here.

First things first – a new prime minister

The first step the Italians must take is to form an interim government. They have a president and prime minister system, so the president, Sergio Mattarella, must now organise this. He will be hoping to install a temporary leader that the governing party will accept in order to avoid an early election.

Many worry that if Italy went to the polls now, the anti-establishment party Five Star Movement would rise to power, which could spell the beginning of the end for the eurozone (the 19 countries within the European Union that use the euro currency). Unlike the Brexit and Trump votes, whose results were neck-and-neck, Renzi lost by quite a margin and Italians seem to be saying they are fed up with years of low growth, weak wages and high unemployment.

Five Star has said it would like to hold another referendum asking Italians if they want to exit the eurozone (which may or may not be allowed by Italy’s constitution). Some economists believe Italy has been disadvantaged by adopting the euro currency, which has made its exports and tourism more expensive and its economy less competitive. They believe returning to their own currency could help boost economic growth; however, Renzi and Mattarella firmly support staying in the eurozone.

Either way, a caretaker government is probably less likely to effect significant progress in key reform areas.

Secondly, Italian banks need a plan B

One of the major concerns of the Italian economy is the condition of its banks, which are among the worst capitalised and most indebted in Europe. Renzi has been pushing for reform in this sector, encouraging recapitalisation of some of the country’s biggest banks, including Monte Paschi and Unicredit. The worry now is that sentiment may turn against these efforts.

Without recapitalisation, the banks could collapse and a banking crisis in the eurozone’s third largest economy would almost certainly push the whole area back into recession. Alternatively, Italy’s government would be faced with the prospect of a state-sponsored bail-out of the banks’ bondholders, which is only likely to further agitate the political situation. The risks of these flow on effects means European financial stocks generally are an area for investors to tread carefully right now.

Thirdly, how Europe responds

The European Central Bank (ECB) is pulling the strings. Stock markets, bond markets and the euro currency all depend on its decisions, which was evident following its announcement today that it would continue with its economic stimulus program past the scheduled end date of March 2017. It will also keep rates at current (negative) levels.

The stimulus includes a substantial bond purchase program, through which the ECB is buying European governments’ bonds, as well as some non-financial company bonds, in a bid to keep money flowing through the economy and raise confidence among business owners, consumers and investors.

The ECB will now continue buying bonds until December 2017, it has said, although after March it will reduce the amount it is spending slightly. Although many anticipated the outcome from today’s board meeting, European stocks still rose more than 1% in the hours following the announcement.

Bonds also got a sudden boost (which means yields fell and prices rose) when ECB president Mario Draghi told the press he would be changing some of the previous purchase conditions to allow them to buy more types of bonds, with lower yields. In particular, German government bonds (bunds), which are viewed as a safe haven in the eurozone and had previously been unable to be purchased, rose in value as Mario spoke.

Meanwhile the euro currency has been volatile since Italy’s vote and is likely to remain so over the coming year as political risk from French, German and Dutch national elections continue to unsettle economies and markets.

Learn more: Currency and its impact on your investments

Which funds?

Despite all the challenges, however, it’s important to remember there are plenty of good companies in Europe with solid growth prospects, regardless of the macroeconomic environment. Most long-term investors with a balanced portfolio will still want some exposure to these opportunities, and I like Elite Rated BlackRock Continental European Income for a fund with a solid process and a good manager track record.

It invests in a lot of defensive-type stocks, which means it has had a bit of a tough year as cyclical industries have been in favour. But if you believe, like me, that we might be in for a rougher ride in Europe over the next year, then you may want exposure to these types of companies with quality earnings and more stable dividends.

Another option is Elite Rated Mirabaud Equities Europe Ex UK Small & Mid. Manager Ken Nicholson is a good stock picker for times like these, precisely because he does tend to ignore European politics and greater economic challenges and focus on finding companies he believes have the best potential to deliver shareholder returns.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views of the author and any people interviewed are their own and do not constitute financial advice.