Graham McDevitt, Global Strategist, Fixed Income and Currency
Tuesday 14 February 2017
Tick tock goes the European political clock
Graham McDevitt, Global Strategist, Fixed Income and Currency
The rise of populism in politics is not a new theme and has been gradually building in the years since the 2008 Global Financial Crisis, but exploded in 2016 with the UK referendum on Brexit and the U.S. Presidential election. Financial markets withstood the shock from Brexit because the Bank of England moved quickly to ease monetary policy, while in the case of the U.S. election it was the prospect of fiscal policy easing and deregulation that spurred risk markets higher. In both cases, the rise of populism has increased uncertainty for financial markets.
In 2017 the European political environment will be put to the test with elections to be held in the Netherlands, France and Germany while the situation in Italy is fluid and could result in an early election. For financial markets and investors each of these poses an event risk. The chart below is a measure of the rising level of uncertainty across financial markets.
Key political events and risks in 2017
Source: Macquarie Fixed Income and Currency Team, January 2017.
The current expectation for the various European elections is that the status quo will be maintained in the end. However, for financial markets there are two important considerations:
- Opinion polls failed to predict the 2016 outcomes in the UK and the US
- The European Central Bank has already begun a subtle shift away from its 'do everything it takes' easy monetary policy stance
Thus, the cosy ‘contained chase for yield’ environment from recent years could be under threat. The obvious question to ask is what could happen to European markets in the event of political surprise in 2017?
Europe in 2017
The election schedule in Europe for 2017 are the Netherlands (15 March), France (7 May) and Germany (likely 24 September) while the Italian political environment is far from stable and an early election cannot be ruled out.
The Netherlands 150-seat House of Representatives is composed of multiple parties that need to form a coalition to govern. Focus is on the performance of the “Eurosceptic” Party of Freedom as it states an intention to leave the European Union (EU), who won just 12 seats in 2012 but are forecast to win between 29 and 35 seats at the upcoming election. So, while the Dutch election will be an important gauge in the rise of populism within the EU, at this point the likelihood of a radical change in the Netherlands is unlikely as other parties can still form a governing coalition. That said, a strong performance by the EPF will embolden the populist movements in other EU countries.
France is perhaps the most important election in the EU in 2017. The focus here is on the performance of Marine Le Pen from the National Front (NF) who is expected to make the run-off vote for President. The NF new rally cry is ‘the people v the elite’, that is, a cry for change that echoed in both the UK and the U.S. Immigration and sovereignty are key platforms for the NF, just as it they were in the UK Brexit referendum. And so this could be the big fear for financial markets, would Marine Le Pen take France out of the EU? This is not known, but the fear would be there and this fear would ripple across asset markets in Europe.
In Germany the Christian Democratic Union/Christian Social Union coalition governs in a grand coalition (for the third time) with the Social Democratic Party. The populist focus here is on the performance of the “Eurosceptic” Alternative for Germany Party (AGP). Polls showed their support rising from around 5% between 2013 and mid-2015 to around 15% at present. So, AGP are set to have a voice in parliament but unless a much larger swing unfolds their voice is likely to be noisy but peripheral.
So, a detailed look through the electoral calendar in Europe shows that populism is indeed on the rise but only in France does there seem to be acute risk of a shock result that could unsettle financial markets.
For a global bond manager the rise of populism and potential spread into Europe is important. Partly because it introduces uncertainty to investment decision making but also because it threatens a change in the policy environment. For 2017 we believe that the French election poses most risk for a surprise.
Perhaps the most obvious asset market risk is the Euro currency. A populist President in France would increase the risk of EU-break up. During the EU sovereign crisis, between May 2011 and July, similar fears lead the Euro to fall by almost 20% against the US Dollar. This reinforces our core view for the first half of 2017 to be overweight the US dollar, based on:
- the better growth differential of the US;
- the prospect that easier fiscal and regulatory environment will boost nominal growth; and
- the Federal Reserve (Fed) looking on course to hike rates further during 2017.
The risks facing Europe suggest there is potential for the Euro to test parity with the US dollar in the months ahead, while victory for the NF in France could cause a much lower spike for the currency.
For European bonds, one potential impact could be a widening in the France-Germany yield spread, which went from 40-50 basis points to a high of 200 basis points during the EU sovereign crisis, a clear sign of markets pricing in a higher risk of EU break-up.
Globally interest rates
Finally, we need to consider the European election risk in the context of global interest rate trends. Here the focus of investors is on the upside risks to U.S. bond yields should the Fed hike interest rates and the new administration deliver substantive fiscal easing that pushes up growth and inflation. However, the bond yield differential between the U.S. and Europe has already widened to levels not seen since 1989. Coupled with the rising political uncertainty in Europe, we are favouring US Treasury bonds over European bonds, as we expect investors would turn to the U.S. as a safe haven in the event of shock election results in Europe.
In 2017 the European political environment will be put to the test. As we wrote in our 2017 Outlook, we are reminded how much the bond markets can be moved by sentiment and other non-technical factors. Our expectation is that 2017 will be a year of small steps and careful navigation.
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