Important disclosures and certifications are contained from page 10 of this report. www.danskeresearch.com

Investment Research — General Market Conditions

On 4 December, Italians are set to vote on the constitutional reform proposed by Prime

Minister Matteo Renzi. The aim of the constitutional reform is to bring political

stability to Italy by diluting the power of the senate and the regions, thus empowering the

government.

Supporters of the bill argue that the new constitution would bring much-needed political

stability (Italy has had 63 governments since 1945) and allow governments to push through

important growth-enhancing reforms, which might otherwise be rejected by the senate.

Critics argue the government will become too powerful and that the issue is not passing

reforms but executing them in the inefficient bureaucracy.

The referendum has more aspects than the constitutional bill – not least with increasing EU

scepticism and following the UK’s Brexit vote and Donald Trump winning the US election.

Originally, Renzi announced that he would step down if he loses the vote but later

members of the coalition said the government would stay in place. Over the weekend,

Renzi’s resignation seemed to be confirmed in the case of a ‘No’ vote, as he said the

government would fall if he loses the referendum.

Polls from the end of October suggest the referendum is likely to be rejected by

around 52% ‘No’ votes on average but some polls suggest up to 50% of the population

has not decided. Observers note that the referendum has become a way for the population

to express discontent with Renzi’s government, the 2017 budget and growth initiatives.

The outcome of the referendum is of high importance for the Italian economy and European

market sentiment. If accepted, the bill could boost confidence in the recovery of the

Italian economy, create political stability and reduce uncertainty about the future of

the euro area. Italy has been one of the worst performers since the financial crisis. Contrary

to most euro area economies, Italian GDP has still not returned to its pre-crisis level and

the country is coping with a large public debt and deficit (respectively 132.7% and -2.6%

of GDP) and a high share of non-performing loans (18% of total loans). On top of this, Italy

has Europe’s fifth highest unemployment rate (11.7%), a very high youth unemployment

rate (37.1%) and low productivity. Accepting the bill should boost the government’s ability

to cope with these issues but depending on the political development and the design of the

new electoral law, the Five Star Movement could gain power in the next election (see more

on the following pages).

However, if rejected, the referendum could throw Italy into new political disarray and

increase uncertainty stemming from the rising euro scepticism across the euro area.

According to the Italian government and other economists, 2017 growth will fall from 1%

to around 0.6% without the budget and growth-measures suggested. Additionally, the

political uncertainty that arises around the future of Renzi’s government could hurt market

sentiment as the influence of the Five Star Movement could increase (see more below). The

Italian population is already among the most sceptical regarding the euro (see Unchanged

support for the euro before Brexit but optimism about EU’s future is lower, 1 August).

22 November 2016

Senior Analyst Pernille Bomholdt Henneberg +45 45 13 20 21 perni@danskebank.dk

First Year Analyst Aila Mihr +45 45 13 78 67 amih@danskebank.dk

Assistant Analyst Christian Belling Sørensen chsr@danskebank.dk

Research Italy

No ‘Italexit’ in the case of a ‘No’ in the referendum

Key facts

Population (2016): 60.7m.

GDP per capita (2015):

EUR27,000, ninth highest in the

euro area.

Government type: Republic with an

upper house (Senato della

Repubblica) and a lower house

(Camera dei Deputati).

Government coalition: PD, NCD,

UdC, SC, Ppl, Demo. S, PSI, CD.

Prime Minister: Matteo Renzi,

Democratic Party (PD).

President: Sergio Mattarella.

Central Bank Governor: Ignazio

Visco.

Economic characteristics

GDP still below pre-crisis level.

Large public debt.

High youth unemployment.

High degree of political instability.

Struggles with corruption.

Troubled financial sector.

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Scenarios after the referendum – market reaction dependent on the political path

Source: Danske Bank Markets

Political impact of a ‘No’ vote

The big question in the case of a ‘No’ vote is whether Prime Minister Renzi will

honour his initial pledge to step down or stick to his later stance that his initial

comment was a mistake. Although Renzi has declined to comment on this question for

the past two months, there have been some signals that stepping down is a very likely

outcome. On 14 November, he indicated that he may not stay on if the referendum fails,

saying that he would not take part in any attempt to form a temporary or technocratic

government. A resignation by Renzi in the case of a ‘No’ vote was also confirmed by his

latest remarks on 20 November that the government would fall if he loses the referendum

and that we would then have to see which parties can reach agreement for a new

government.

Scenarios and related probabilities following a ‘No’ vote

Source: Danske Bank Markets

‘ YES’

Initial positive market reaction

Renzi continues growth reforms. Work on new

electoral law

Weak support for Renzi’s government

Care-taker government and snap election

Referendum on Italy’s constitutional reform

Renzi steps down

New government/coalition serving as placeholder until election in 2018

Renzi stays PM

Election in 2018based on revised Italicum

Renzi gets second term with more government

power

Focused on new electoral law. No reform progress

Negative market reaction. Uncertainty about Italy’s future in the euro / EU

Positive market reaction. No/little uncertainty about Italy’s future in euro / EU

The Five Star Movement emerges into power

Strong support for Renzi government

Initial negative market reaction

President Mattarella accepts Renzi’s

resignation

President Mattarella rejects Renzi’s

resignation

Snap election in H1 2017based on current Italicum

Snap election in H2 2017based on revised Italicum

Coalition government

Strong reform progress. Work on new electoral law

‘NO’

Renzi is not likely to take part in new government

Renzi steps down

No elections before revised 'Italicum', but technocratic

transition government

Baseline scenario

70%

Renzi steps down

Early elections in H1 17 under current 'Italicum' and Five Star

Movement in government

Alternative scenario 1

5%

Renzi stays PM

Weak and fractured PD government

Alternative scenario 2

25%

Referendum polls showing ‘ No’ vote in

the lead (undecided not included)

Source: Macrobond Financial, Danske Bank

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If Renzi resigns, President Sergio Mattarella would be likely to nominate an interim

government before dissolving the lower house and calling early snap elections for

2017, as elections should be held within 70 days of the President dissolving Parliament.

Predicting the outcome of such an election is complicated and is likely to be highly

dependent on whether or not the new electoral law – ‘Italicum’ – will still be in place in an

unchanged form when the election takes place. Given that Renzi has said that Italicum will

be changed no matter what the outcome of the referendum and that there is broad political

support for such a move, it is likely that snap elections for 2017 would not proceed under

the new electoral law in its current form. With a revised electoral law that excludes the

majority bonus for a single party, we would be likely to see again a coalition government

in place, limiting the chances of the Five Star Movement gaining power (see below).

Facts about Italicum – the new electoral law

The aim of Italicum is to prevent governments of unstable coalitions, as Italicum gives the party

winning at least 40% of the votes in the first round or winning a second round between the two

biggest parties, a large number of bonus seats to ensure it has a 54% majority (340 out of

630 seats) in the lower house.

Italicum entered into force in July but the constitutionality of the new law has been challenged

in the constitutional court and a final ruling is not expected before early next year.

Italicum will be revised regardless of the outcome of the constitutional reform on 4 December.

Renzi has stated that Italicum will be changed and there is a broad political support for this.

In the case of a ‘No’-vote, rejecting the government’s reform plans would make it more likely

that the Italicum would be abandoned altogether and it is likely we would see a return to the

old proportional representation electoral system also used in the Senate.

In case of a ‘Yes’, this would reduce pressure on the government to amend the Italicum;

however, there seems to be broad support among the PD and some opposition parties for

revising it towards a majority bonus for a coalition instead of a single party, to minimise the

risk of anti-establishment parties coming to power after the next general election. Given the

Five Star Movements’ opposition to forming coalitions, such a move would severely weaken its

chances.

Source: Danske Bank Markets

However, in the event that the election should take place very early in 2017, before the final

ruling of the constitutional court, there is a risk that voting could proceed under the Italicum

in unchanged form. Should voting proceed under the new electoral law without

changes, it would benefit the anti-establishment Five Star Movement. By capturing as

little as 30% of the popular vote in the first round, it could end up with a clear majority in

the lower house, by winning the second round run-off and receiving the bonus seats.

Currently, the Five Star Movement is head-to-head with the PD in most opinion polls,

making it still a likely candidate for the next government in the absence of certainty

on planned changes on Italicum. Members of the movement were already elected as

mayors of Rome and Turin in 2016. Although the Five Star Movement has pledged a

referendum on the euro, it has stopped short of advocating an immediate exit from the EU.

Furthermore, it is not clear that if such a referendum were held, the majority of Italians

would vote in favour of an exit, as support for the EU among the population actually

increased after Brexit according to an IFOP poll. An imminent ‘Italexit’ therefore seems

unlikely for now.

Polls show Five Star Movement head-

to-head with Renzi’s PD

Source: SWG, Danske Bank Markets

05

10152025303540

Five Star Movement PD Forza Italia%

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Apart from calling new elections, President Sergio Mattarella has other options to resolve

a potential political impasse following the referendum. He could reject the resignation of

Renzi if he can command a majority in parliament, replace him with a technocrat as

happened in 2011 when Mario Monti replaced Silvio Berlusconi or grant someone else the

right to form a government. If the other parties in the governing coalition support such a

move, the caretaker government would then take over until the next scheduled general

election in 2018. However, given that Renzi has said that he would not be willing to seek

a deal with other parties to form a temporary or technocratic government if he loses the

referendum, such a move seems unlikely.

Finally, Renzi could decide to stay as Prime Minister, as he is aware of the likelihood of

the Five Star Movement winning an early election, particularly as its momentum should be

strong after a ‘No’ in the referendum. In this scenario, Renzi’s party’s popular mandate

would still be dramatically weakened but the hope would be that ‘something’ could

change ahead of the election in 2018. This said, divisions within the PD party between

Renzi backers and traditionalists such as former PD leaders Massimo D’Alema and Pier

Luigi Bersani, who criticise Renzi for moving the party too far to the right, pose the risk of

a weak, fractured government and a slowdown of reforms, potentially leading to a

government crisis and early election in 2017.

Timeline after a ‘No’ vote

Source: Danske Bank Markets

Economic impact of a ‘No’ vote

According to the Italian government, GDP growth in 2017 will fall by 0.4pp without the

suggested budget and growth-measures. Added to this, there could be some negative impact

from higher political uncertainty but, in our view, the short-term effects of higher

political uncertainty may not be that large in Italy, as the country is used to political

instability, implying a likely small impact on consumer and business confidence.

Additionally, the experience from the Brexit vote and the US election is that a new political

agenda will not affect economic sentiment to a large degree. Finally, having a caretaker

government for a period of time would not necessarily be negative for the near-term growth

outlook or implementation of economic reforms. Based on this, we expect limited

economic impact in the short term.

Today

Q22016

Q3 Q4 Q12017

Q2 Q3 Q4 Q12018

Parliament approves reform bill

12-04-2016

Government setsreferendum data

26-09-2016

Obama endorses ‘yes’19-10-2016

‘No’ vote in referendum04-12-2016

Renzi steps down as PM05-12-2016

President accepts Renzi’s resignation

12-12-2016

Politicians working on changing ‘Italicum’First part of 2017

Snap elections if no government 12-12-2016 + 70d

Latest date for new election23-05-2018

Q2

Interim governmentand new election

2nd half 2017

A low share is against the euro in Italy

Source: European Commission Eurobarometer,

Danske Bank Markets

IE13%

BE20%

FI20%

NL21%

DE22%

FR24%

AT25%

PT26%

EA26%

SP27%

GR34%

IT35%

EU38%

DK65%

SE71%

UK76%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90% Ratio being against the euro as a common currency

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In a longer term perspective, the political instability connected with a ‘No’ vote is

likely to imply fewer structural reforms and continued problems in terms of bringing

the economy to a solid recovery. Italy is also likely to continue to be challenged by

bringing down its very high public debt, while the fragile banking sector could also have a

negative impact on the economic outlook.

Market reactions

In our view, a ‘No’ vote would mean prolonged uncertainty for global investors and

trigger political turmoil. Uncertainty on ‘what is next’ is likely to cause elevated

volatility and further shake confidence in the European project. A ‘high’ political risk

premium is already priced in the Italian government bond market with Italy having

underperformed Spain by 30bp since early September, mainly on political woes. Renzi

himself said that he expects high market volatility in the run-up to the referendum. Given

Italy’s sizable government debt (130% of GDP) and the possibility of a slowdown in reforms

and growth, questions about the direction for Italy (and Europe) have the potential to drive

global risk sentiment around the referendum date. These fears could spill over to other

periphery countries. The political impasse would also heighten concerns about Italy’s

banking system, with its large share of non-performing loans. Economic and political

uncertainty would weigh on the EUR and depress investments and future potential growth.

This said, the market reaction is very dependent on the political path following the ‘No’ vote.

As spreads have already widened significantly ahead of the referendum, we do not rule out

that we could see tightening even in a ‘No’ scenario (‘sell the rumour – buy the fact’).

Outlook for key economic variables

Source: OECD, IMF, European Commission, Danske Bank Markets

What does the Five Star Movement stand for?

The Five Star Movement (M5S) was founded by comedian Beppe Grillo and IT executive

Gianroberto Casaleggio in 2009. M5S has become Italy’s second most popular party and

its biggest opposition group, as support for the movement’s push for direct democracy and

its anti-establishment and anti-corruption campaign surged among the population. At the

previous lower house elections in 2013, the M5S took 25% of the vote.

Within the movement, online ballots are used to set policy and select and expel candidates and

it plans similar online referendums on political issues once in government. In contrast to other

populist movements in Europe, which are clearly associated with either the political right or

left, M5S has attracted votes across the political spectrum. While left-wing voters respond to

its pro-environment, anti-austerity and anti-capitalist stance, right-wing voters are

attracted by its tough stance on immigration and opposition to the EU and euro and its

alliance with other right-wing parties in the European Parliament, such as UKIP. However, this

characteristic also makes the movement vulnerable to internal clashes, as left- and right-leaning

members increasingly seem to disagree on policy and issues such as privatisation or abortion.

2016 2017 2016 2017 2016 2017 2016 2017 2016 2017

Danske Bank 0.8 0.9 -0.1 1.3 11.5 11.3 -2.5 -2.0 132.9 133.0

IMF 0.8 0.9 -0.1 0.5 11.5 11.2 -2.5 -2.2 133.2 133.4

OECD 0.8 0.8 0.2 0.9 11.3 10.8 -2.3 -2.0 132.8 131.9

EU (Commission) 0.7 0.9 0.0 1.2 11.5 11.4 -2.4 -2.4 133.0 133.1

1) % y/y. 2) % of labour force. 3) % of GDP.

Italy - Outlook for key economic variables

ItalyGDP (1) CPI (1) Unemployment (2) Govt. Budget (3) Govt. Debt (3)

Yields have been rising since August

in anticipation of the referendum

Source: Macrobond Financial, Danske Bank

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Apart from internal fragmentation, another big challenge for the movement comes in the

form of its electoral candidates’ inexperience in questions of governance, politics and

economics. The new M5S mayor of Rome has already made a disastrous start, struggling

over administrative hurdles due to her inexperience. Faced with economic challenges or a

renewed banking crisis, an M5S government hence seems unlikely to come up with timely

and adequate policy responses, especially as it has voiced strong opposition to previous

public invention on this front. Its anti-austerity stance would also put it on a collision course

with the European Commission and fiscal largess would aggravate concerns about the

sustainability of the public debt burden.

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Italian GDP has by no means recovered to 2008 level PMIs signal continued modest Italian GDP growth

Source: Eurostat, Danske Bank Markets Source: European Commission, Danske Bank Markets

The declining trend in the unemployment rate has stopped Italy’s youth unemployment is still much higher than euro area’s

Source: European Commission, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

Government budget has improved post crisis but still deficit Italy’s public debt may have peaked but at a very high level

Source: Eurostat, European Commission Danske Bank Markets Source: European Commission, Danske Bank Markets

Inflation and core inflation remain far from ECB’s 2% target Italy’s output gap has been larger than the euro area

Source: Eurostat, Danske Bank Markets Source: OECD, Danske Bank Markets

-6

-4

-2

0

-6

-4

-2

0

Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17

% points% points Output gap

Euro Area 15 OECD Countries United States Italy

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Private consumption has also lagged behind Consumer confidence has weakened this year

Source: Eurostat, Danske Bank Markets Source: Fitch, Moody’s, S&P, Danske Bank Markets

Almost no growth in Italian investments Industrial production has also struggled to recover

Source: Eurostat, Danske Bank Markets Source: Fitch, Moody’s, S&P, Danske Bank Markets

Industrial confidence around its historical means Still high business and consumer confidence

Source: European Commission, Danske Bank Markets Source: European Commission, Danske Bank Markets

Current account surplus close to euro area Low exports share of GDP in Italy

Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

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Nominal unit labour costs rose faster than in euro area Productivity lags behind the euro area

Source: Eurostat, Danske Bank Markets Source: European Commission, Danske Bank Markets

Population is projected to decline in line with euro area Italian employment growth weak compared with euro area

Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

Housing prices have not bottomed out in Italy yet Construction permits very, very low

Source: Eurostat, Danske Bank Markets Source: Macrobond Financial, Danske Bank Markets

Higher yields recently but still low in a longer term perspective Low Italian debt ratings from all three agencies

Source: Macrobond Financial, Danske Bank Markets Source: Fitch, Moody’s, Standard & Poor’s, Danske Bank Markets

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Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’).

The authors of this research report are Pernille Bomholdt Henneberg (Senior Analyst), Aila Mihr (First-Year

Analyst) and Christian Belling Sørensen (Assistant Analyst).

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See the front page of this research report for the date of first publication.

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