At least initially, Italy could call the shots for global markets in the week ahead, as the Trump rally begins to show signs of tiring. The dollar, bonds and stocks should continue to take their cue from any hints of policy or plans from the incoming Trump Administration, and there are a few U.S. economic reports like trade data and consumer sentiment. But the whole world is watching Italy's constitutional referendum Sunday to see if it could cause the next Brexit-like tremor for markets. "Particularly if the focus shifts to Europe, we think that these Trump themes could very well pause here with interest rates arguably up 70 basis points. The rally could very well have been front loaded," said Julian Emanuel, equity and derivatives strategist at UBS. Emanuel said the rallies in sectors like industrials and the small caps are showing signs of wear. Even though the Italian referendum is "very Eurocentric," Emanuel said U.S. investors began to shift their attention to the uncertainty around it just as the U.S. stock market rally slowed in the past week. The was down nearly a percent at 2,191 in the past week, its first weekly loss in four weeks. Treasury yields were slightly higher after an extremely volatile week, with the U.S. 10-year at 2.39 percent Friday after nearing 2.5 percent Thursday.



Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., November 7, 2016. Brendan McDermid | Reuters

Strategists say even though the markets expect a no vote in Italy on Sunday, gauging the immediate reaction has been difficult. "Italy is the biggest wild card. We'll have to see how the referendum goes and more importantly how do markets in Italy respond to that whether or not there's a big jump in perception of risk among Italian financial names," said Boris Rjavinksi, director, rate strategy at Wells Fargo. Italy is also being watched as one of a number of European countries where voters in coming months could favor nationalist themes and populist movements, in the aftermath of the U.K. Brexit vote to leave the European union. Austria, for instance, has an election on Sunday, and the right-wing presidential candidate has been leading in the polls. In Italy, the referendum is not an election but it has turned into a vote of confidence in Italian Prime Minister Matteo Renzi. Renzi, a reformer, has proposed constitutional reform that would change the structure of government by reducing the size and makeup of the Senate and centralize more powers. The current system, with votes needing to pass both a large Senate and lower House, has resulted in years of gridlock. Renzi has said he would step down if there is a no vote, but it's not clear whether he would. "The polls are suggesting a no vote. In contrast, with Brexit and Donald Trump, the polls were suggesting the opposite. The surprise result would be a yes vote, and in that scenario you would expect to see some very big moves in the assets exposed to that. You've seen significant underperformance of Italian banks in recent months, and going into this referendum, you've seen spreads between [Italian bonds] and bunds widen," said Richard Turnill, global chief investment strategist for BlackRock. Turnill said even though the markets are expecting a 'no' vote, there could still be a reaction. "I think you'd see it particularly in the Italian banks. I think you'll see it in the spreads of Italian bonds over German bunds, and you could potentially see it in the euro. The lessons of Trump and Brexit is not to overestimate the market reaction," said Richard Turnill, "We really don't see the Italian referendum leading to significant financial contagion, even in Europe." Marc Chandler, chief fixed income strategist at Brown Brothers Harriman, said based on this past week's actions, the market response could also turn out to be relatively calm. If Renzi steps down, he said he would be replaced by a technocrat from his own party who would be in office until the next election in 2018. But Chandler said the risks are that the vote could enable the populist Five Star party to gain ground in the 2018 election. That party, led by a former comedian, is opposed to the euro, and if it does succeed, it could be a major upset down the road for financial markets and Italy's banking system.



"Look what happened this week. Italian bonds have done the best in Europe. Italian stocks have done the best in Europe. Italian banks are up 5.2 percent. It means that people think that it's going to be a nonevent," he said. The political turmoil comes at a bad time for Italian banks, which need capital. Its most troubled bank, Monte dei Paschi, needs more than $5 billion by year end. Its efforts to raise capital could be stalled by the referendum if the no vote prevails. Its stock has lost 84 percent this year on concerns about its nonperforming loans and capital level. "Come Monday, nothing's really going to change in Italy. If the prime minister wants to pass a law and he doesn't have support, he passes it by decree. Renzi has had to rule a lot by decree. My suggestion is the new technocrat government would rule by decree," he said. Turnill said he is cautious on European stocks because of the uncertainty around political issues. "Interest rates remain low in Europe and that raises real challenges for particularly the European banks," he said. Markets are also watching the European Central Bank's meeting Thursday, where it is expected to announce an extension of its quantitative easing program. "The real risk in Europe is you get a domino effect over time, [where] there is a path to power for more populist parties," said Turnill. That could ultimately strain the euro. "The forces driving the resurgence in populist parties in Europe remain very powerful and may increase. We have the Austrian election, then the French election." On Thursday, French President Francois Hollande announced he would not seek a second term. "I think the biggest single risk event will be the French election, where in the event Marine Le Pen wins the election, I think people would be very nervous about what the implication of that would be for the euro zone going forward. The outcome of the recent primaries appear to have reduced that probability, but I think we've all learned the elections are becoming increasingly unpredictable," he said. In the U.S. in the coming week, U.S. economic data includes international trade Tuesday and consumer sentiment Friday. There is also China PMI data Monday, trade balance on Thursday and inflation data Friday. "I think people will start thinking about the upcoming FOMC meeting. That's kind of the road map for the next week. There's some data, but not as high profile as we got this week. I think it's about time for the market to start thinking about positioning for the FOMC. We expect a 25 basis point hike, tempered by fairly cautious language, as far as the forward guidance goes," said Rjavinski. The Fed meets the following week and is widely expected to raise the Fed funds target rate by a quarter point on Dec. 14, its second interest rate hike in 10 years.