How global markets will react to Italy vote

As Italy prepares to vote in Sunday's referendum on constitutional reform, global equity markets are looking at a third potential crisis in less than six months. To be fair, equity markets have brushed off uncertainty many believed would cripple them, but could a 'no' vote be third time unlucky?

Here's what the Italian referendum decision could mean for markets next week, and we've also included some stocks to see you through the drama.

This isn't exactly Italy's 'Brexit' moment, as it's not deciding whether to leave the European Union, but Sunday's vote could still trigger political and financial turmoil. Prime minister Matteo Renzi has said he will resign if Italy votes against his reforms, putting the country in political crisis and potentially plunging the euro into turmoil.

Or, if reaction to Brexit and the US election is anything to go by, doomsday predictions will prove unfounded and markets could rally.

In a bid to overhaul the Italian political system, Renzi wants to make big changes. Italy currently elects lawmakers to two chambers of parliament with equal power - Chamber of Deputies and the Senate. As both currently need to agree legislation before it is passed, this process can be both lengthy and complicated.

The prime minister wants to reduce the number of senators from 315 to 100, each of which would be selected by regional assemblies, not elected. As a result, the Senate would lose nearly all its power, allowing most laws and Italy's Budget to be passed by the Chamber of Deputies alone.

As parliament approved the changes by just a slim majority, the reforms must be agreed by the Italian public. The choice will be 'yes' to back Renzi's reforms, or 'no' to back the opposition, who argue the proposals are undemocratic - this isn't a clear Right versus Left debate.

Many see itas a plebiscite on Renzi, however, who was the boy wonder when elected in 2014, but high unemployment rates and migration concerns have affected his popularity.

It's the undecided voters who will determine the result, with the latest polls pointing to a quarter of Italians still sat on the fence before the pre-vote opinion poll ban. However, if we've learnt anything this year, it's that we have to take polls with a pinch of salt. But the 'no' camp has taken the lead, and most market commentators are preparing for Renzi's resignation come Monday morning.

"Much of this would be largely an irrelevance to markets outside Italy, were it not for the economic backdrop, most especially seen in the ongoing banking crisis," explains Liontrust fund manager Olly Russ.

"Italy is a very different banking market from much of Europe, and its current crisis stems from different causes to that which devastated the sector elsewhere in 2009 onwards.

"Italy's problem is not sub-prime or consumer debt, but the slow suffocation of its vital SME sector, which has been held back by euro membership and the lack of substantial labour market reforms. Italian competitiveness has suffered within the common currency as real wages rose despite high levels of unemployment.

"Unable to devalue within the euro, growth has accordingly been anaemic for decades. This has now led to corporate debt defaults which threaten to overwhelm the capital base of some of the second-line banks."

Against flat German and French markets, Italy has lost nearly a fifth of its value this year as a result of its banking crisis, referendum nerves and equity valuations relative to Europe close to March 2009 and July 2012 crisis levels, according to data from UBS.

It's the cheapest stockmarket in Europe. There's been pre-referendum nerves in the financial markets, too, with panic seen in some European banking socks and a spike in the Italian-German bond yield spread.

"While current valuation levels may appear attractive and support a straightforward 'value call', we suggest a more balanced and selective approach to stock-picking amid poor visibility," warns UBS economist Felix Huefner.

So we are soon to look the third crisis on the last six months in the eye, but how will the markets react on Monday?

No

We know Renzi will resign if he loses this referendum, he's already said so, but we don't know whether he will be forced to stay on, or if the President of the Republic Mattarella will elect a caretaker government - FM Padoan or Senate President Grasso are tipped to be waiting in the wings.

But, if the government collapses and a new one cannot be formed, an early election could be called, which could give the anti-establishment and anti-EU Five Star Movement Party the momentum needed to secure a larger majority in parliament.

But as a 'no' vote is now widely expected and nerves are already priced in, European stocks may not react with much aggression.

The German DAX could fall by as much as 5%, while other European counterparts like the French CAC and FTSE 100 could also weaken, experts say. London's blue-chip index should quickly be bolstered by weakness of the euro against the dollar, however, with benefits to miners and oil.

If Renzi's bank bail-out plan is scrapped during the political upheaval, up to eight banks could fail, which will put significant pressure on the euro. If Europe doesn't step in to help the Italian banking sector, the likelihood that Germany's largest financial institution Deutsche Bank will get any help is even smaller, which could spark further weakness across the sector and German lender.

This isn't likely to be enough to spark a financial crisis, but volatility is expected. Of course, the markets could react to the uncertainty a 'no' vote brings just like they did after the American presidential election.

Investors will look to the European Central Bank meeting for direction - will it continue its €1.74 trillion quantitative easing programme? While a 'no' vote won't trigger an immediate downgrade to BBB, it could be the catalyst.

Investors should look for low beta stocks during the possible market sell-off, like coffee machine manufacturer DeLonghi, online retailer Moncler, transport group Atlantia, energy firm Eni, utility company Enel, and insurer Poste Italiane, says UBS.

Yes

The markets will breath a sigh of relief if Italy votes 'yes' on Sunday, which could allow Italian bond yields to unwind back from around 2% to 1%. UBS reckons the market could bounce by 10-20%.

Shorters will close their positions, which will help underpin a strong rally as the market starts unwinds the recent sell-off - keep an eye on Unicredit and Banco Monte dei Paschi di Siena. The banks will know they have Renzi's bail-out package, but the path ahead will still be challenging.

We know Renzi will hold onto his job if Italy votes 'yes', but this doesn't mean he'll have an easy time. UBS reckons political uncertainty will continue until the next general election in 2018, with the electoral law holding the most risk.

High-beta banking an finance stocks Creval, BPER, Intesa SanPaolo and Anima Holding should benefit from a 'yes' vote, along with Mediaset, global tech group Leonardo, energy group Saipem, construction materials group Buzzi Unicem and insurer Generali, tips UBS.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.