By Riva Gold and Giovanni Legorano

After Brexit and Donald Trump, investors are focused on Italy as they position themselves ahead of what could be the latest political event to rattle markets and upend politics.

If rejected, a Dec. 4 referendum in Italy has the potential to send the country's bank shares tumbling, push bond yields up and further weaken the euro.

The vote is on a constitutional overhaul presented by Prime Minister Matteo Renzi that aims to speed up lawmaking and produce more stable governments. Mr. Renzi has pledged to resign in case of a "no" vote. With the economy in the doldrums and the 41-year-old premier's popularity waning, the referendum has effectively become a confidence vote on the government and its efforts to revive the economy.

The referendum is "setting the tone for 2017" on the political and investment climate in Italy and across Europe, said Wolf von Rotberg, European equity strategist at Deutsche Bank AG.

Recent polls put the "no" vote just ahead, with more than 20% undecided. That has unnerved investors, who worry about political instability in a country that is one of Europe's most indebted and grappling with battered banks, years of economic stagnation and increasing euroskeptic sentiment.

"If a 'no' vote wins, everything remains as it is," Mr. Renzi said in a radio interview this past week. "In this way, Italy will remain a system that favors instability and backdoor dealings."

If the prime minister -- considered one of Europe's most reform-minded leaders -- steps down, the most likely outcome is the establishment of a caretaker government.

But that could also bring forward parliamentary elections now slated for 2018. With the antiestablishment 5 Star Movement polling at about 30%, it has a chance at leading a new government. The party's economic platforms include renegotiating Italy's debt and calling a nonbinding referendum on the euro, issues that would destabilize the region as a whole.

To be sure, some investors have pointed to the positive stock-market response to the U.S. election and the recovery in risk assets after an initial selloff following the U.K. vote in June to leave the European Union as reasons to expect any referendum selloff to be short-lived. And the political fallout could be less severe than feared if a credible caretaker government takes over and support for the 5 Star Movement fades.

"When [investors] understand there are a lot of steps in between and the chain of events isn't automatic, they realize the outcome of the constitutional referendum is much less risky than they thought," said Giovanni Zanni, head of economic research for southern Europe at Credit Suisse Group AG.

Indeed, stock investors haven't yet priced in much risk. Italy's stock benchmark, the FTSE MIB, has lost less than 1% since the end of September, even though the banking sector has shed roughly 8% in the four trading days through this past Thursday. If the 5 Star Movement came to power and called a referendum on the euro, the Stoxx Europe 600 index could fall as much as 20%, Deutsche Bank estimates.

One gauge of market fear, the Euro Stoxx 50 Volatility Index, known as the VSTOXX, is trading about 19% below its historical average, FactSet data going back to 2009 show. The index tracks investor expectations of how volatile European stock markets will be based on options prices.

"The VSTOXX is not fully pricing in the Italian referendum," said Ilya Feygin, a New York-based managing director at institutional brokerage Wallachbeth Capital LLC. "It's a big event risk coming up."

But the unpredictability of Italy's politics and its deep economic problems mean the eurozone's No. 3 economy is a perpetual worry for the whole bloc.

If there is a shock in Italy and the European Central Bank can't calm markets, "the potential for contagion to the rest of the eurozone is much greater than Brexit," said Isabelle Mateos y Lago, chief multiasset strategist for BlackRock Inc.

Referendum jitters have already unnerved Italy's government-bond market, the fifth largest in the world. While bonds globally have sold off since the U.S. election, Italy has been among the steepest decliners, with the yield on the 10-year note topping 2% for the first time in more than a year, on track for its worst month since 2012, and the yield on the 50-year Italian bond rising as high as around 3.5% this past week from around 2.9% in mid-October.The spread between Italian and benchmark German government bonds has widened to around 1.7 percentage points, near the highest in two years, though it remains far from the levels seen in late 2011.

The annual cost of insuring against a default on $10 million of Italian debt for five years using credit-default swaps rose to about $170,000 this week from $97,000 at the start of the year, according to data provider IHS Markit.

Most investors expect a further selloff in Italian bonds and a knock-on effect on stocks if the referendum is defeated. That political stress could also further weigh on the euro, which has fallen steadily against the dollar for 10 straight sessions -- its worst losing streak on record.

"We like selling the euro on rallies because the U.S. and U.K. both had their protest votes already," said Stephen Gallo, strategist at BMO Capital Markets. "The eurozone countries largely have not."

The vote isparticularly crucial for Italy's beleaguered lenders, whose shares have nearly halved this year. The focus is on Italy's No. 1 and No. 3 banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, which both plan recapitalization plans including the sale of fresh shares after the referendum. UniCredit's strategic plan will be unveiled on Dec. 13 and is likely to include a EUR13 billion share sale, drastic cost cuts and asset sales. Monte dei Paschi's rescue plan involves the sale of EUR28 billion of bad loans and EUR5 billion in fresh equity by year-end.

UniCredit credit-default swaps are now trading wider than Deutsche Bank for first time since January, according to IHS Markit.

Moreover, Italy's economic success and bank system health remain vital for the region as a whole.

"Italy is bigger than Brexit," said Guy Monson, chief investment officer at Sarasin & Partners. "Until Italy is growing, we can't really say the decade of European crises has passed us."

--Gunjan Banerji and Christopher Whittall contributed to this article.

Write to Riva Gold at riva.gold@wsj.com and Giovanni Legorano at giovanni.legorano@wsj.com

(END) Dow Jones Newswires

November 18, 2016 15:57 ET (20:57 GMT)

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