European political and ECB policy uncertainties reinforce economic concerns.
Italy is the most immediate risk but Brexitcould soon return to centre-stage.
Stay wary on (European) equities and recalibrate portfolios: overall diversification is key
Questions about investment in Europe focus on a range of things, including immediate economic prospects –particularly after an apparent pickup in activity levels earlier this year, and with ECB future policy uncertain. External trade relations are also an issue, given many major European firms’ high export dependency, on China as well as the U.S. But European politics is also an abiding concern, with political frictions often perceived as linked to the functioning of the European Union or the Eurozone. Here we summarize our views not just on the immediate issues of the Italian budget deficit and Brexitbut also on politics in five other economies elsewhere in the region.
Economic backdrop: slower Eurozone growth
Growth in the Eurozone is expected to slow this year. The expected rebound in Q1 2019 materialized, but from now on uncertainty due to trade conflicts and Brexitis expected to weigh on growth. Italy also has the potential to lead to problems in the remaining EU27. Against this uncertain background, for the moment the consumer appears to be the “last man standing”. Current economic momentum comes from consumer sentiment and continued employment gains, helping prop up economic sentiment indicators; so far, this is benefiting services more than manufacturing. However, part of any boost from fiscal loosening this year might end up in higher personal savings as political and economic uncertainty encourages people to put money aside. In short, the consumer cannot be relied on to single-handedly support economic growth for ever: more balanced growth composition is key.
Policy backdrop: the ECB’s difficult way forward
The ECB will need to change its forward guidance on rates gradually in the coming months, due to weaker economic growth forecasts and inflation remaining stubbornly below target. A simple postponement of interest rate hikes from one quarter to another will not remain credible over the longer term; also, a cut in the deposit rate will also remain obviously inappropriate. The experience of the Bank of Japan reminds us that lifting inflation expectations can be very difficult and an extensive quantitative easing (QE) program is not on the agenda, meaning that attention will focus on other policy initiatives. Details onTLTRO3 are likely to be the focus of upcoming ECB meetings. A tiering system on the deposit rate is also possible but this is more contentious and could also have only a limited effect on financial conditions. At present, banks in effect pay a charge to park excess reserves at the ECB: a tiered system would partially exempt them from this, boosting their profitability and thus ability to lend. Depending on the assumptions used, such a tiering system might reduce the EUR7.5bn effective charge on banks for holding excess liquidity in the deposit facility to EUR2.5bn (if we assume a threshold that was 10 times the minimum reserve) – a substantial, but not game-changing, amount. A tiered rate system would also send a signal that rates are going to stay lower for a longer time – potentially limiting the effectiveness of ECB forward guidance. In short, tiering would have costs as well as benefits.
Putting policy topics to one side (we will discuss with the trade issue in a forthcoming publication), domestic political issues will also continue to have an impact on the European investment landscape. We highlight seven issues below which will remain important.
Issue #1: Italian budget deficit will prove difficult to fix
Discussions about Italy’s public debt have flared up again, pushing up the spread between 10-year Italian and German government bonds to around 275 bps, the highest level since last December. Last week, the European Commission sent a letter to Italy citing various sources of concern; as required, the Italian government responded on Friday May 31 saying that it was having a full-scale review into the country’s finances. Their concern is that the European Commission will propose an excessive deficit procedure (EDP) for Italy, which could in theory eventually lead to a fine of 0.2% of GDP (around EUR3.5bn). EU finance ministers would have to sign off the procedure for the EDP, most likely at their next gathering in early July, although they might find reasons to delay, if fearful of political or market consequences.
Even if such a procedure can be avoided once again, Italian’s public finances are likely to remain a market focus. The budget draft for the fiscal year 2020 is due in October 2019 and will likely lead to further tensions as it could include fiscally costly items like the flat tax. Credit rating agencies might anyway go ahead and adjust their ratings for Italy, not waiting for this budget draft. Fitch will review its BBB rating for Italy with a negative outlook on August 9. A downgrade to BBB-, its lowest investment grade rating, would not come as a surprise. The Moody’s review follows on September 6. Moody’s currently gives Italy a Baa3 rating, its lowest investment grade rating on its scoring system. A loss of Moody’s IG status would lead to a further spread widening. Whatever happens, Italy’s high public debt remains a risk for the entire Eurozone. The debt trajectory has been upward sloping lately and hence remains vulnerable to shocks. Fiscal discipline combined with growth-enhancing reforms are inevitable at some point but the political will to implement them seems rather limited – particularly as refinancing costs are still relatively low due to the ultra-loose ECB policy.
Italy’s governing coalition also seems increasingly fragile, particularly after the League’s success in the European Parliament elections, where its coalition partner, the 5 Star Movement (5SM) did badly relative to earlier elections. We might see moves towards a new government.
Issue #2: Brexit resurgent under new leadership
Mrs. May will step down as Conservative party leader this Friday, June 7, and there are at present no less than 11 candidates to replace her. The European Parliamentary elections underlined the existential problems facing the UK’s major political parties which both fared very badly. On the one hand, after losing votes heavily to the new Brexit Party, the Conservatives look set to harden their stance on Brexit and almost all its party leadership contenders have followed this script. On the other hand the Labour Party, which suffered big losses to the pro-EU Liberal Democrats, could eventually fully back a second EU referendum. Altogether, this lowers the odds of a compromise semi-soft or soft Brexit while increasing the likelihood of the more binary outcomes, i.e. hard or no Brexit.
Brexit timelines also threaten quickly to become acute again. The Conservatives will probably use up most of the time from now until the UK parliament is due to head for summer recess on July 24 to find a new leader. We might thus have to wait until parliament returns on September 4 before MPs can address any serious Brexit business. That would leave just two months to sort out Brexit (with annual party conferences further diverting attention). Unless the first act of the new prime minister is to cancel summer recess (not impossible), markets, business and households now face the prospect of months ahead with a lot of noise but no guarantee of progress. Current implied odds suggest that the new prime minister is likely to be a Brexiteer and even though a majority in parliament is against a hard Brexit (as proven many times in corresponding amendments votes to May’s withdrawal agreement in the Commons), this remains the default option on October 31 unless the UK passes the WA or changes its mind on Brexit (i.e. no Brexit at all). The chance that the EU would agree to a third extension just to prevent a hard Brexit is not so high as in April. However, if a snap election or second referendum is agreed to by then, we could have a different story, but with its own set of risks (e.g. a hard-left Corbyn government). But here, too, the possible timeline is getting very tight: technical preparations for a second referendum (even assuming rapid agreement on the alternatives proposed in such a vote – no Brexit/hard Brexit vs deal/no deal etc.) could take us at least 20 weeks, already bringing us very close to the Brexit deadline.
Issue #3: German government coalition under strain
Poor European Parliament election results have increased internal tensions within the CDU/CSU conservatives and also within the SPD socialists. The left wing of the SPD is increasingly questioning the federal-level grand coalition between the two parties. But Chancellor Merkel’s CDU also faces some challenges, particularly in some parts of the east of Germany; the right-wing AfD was the strongest party here in the European elections, which has raised worries about the impending state elections in three Eastern states (Brandenburg and Saxony on September 1 and then Thuringia on October 27).
Current opinion polls for Bundestag (i.e. federal) elections show a similar picture to the European elections, i.e. the CDU/CSU and SPD would lose out compared to last time, with the SPD running the risk of coming in behind the Greens at the federal level. The SPD could therefore be understandably reluctant to precipitate new elections. However, these may have come a stage closer with the decision of Andrea Nahles to step down as chair of both the SPD and the parliamentary group in the Bundestag. This leaves the party in a leadership vacuum with both roles filled provisionally. The next regular party convention is currently scheduled for December 2019. This coincides with the planned half-time assessment of the coalition agreement (which could however be brought forward) and might prove a predetermined breaking point, in particular if a representative of the left wing of the SPD and opponent to the grand coalition takes over.
Leadership questions are also being asked within the CDU. Annegret Kramp-Karrenbauer has been chairing the CDU for half a year now. So far, Merkel intends to remain chancellor until the end of the current tenure in 2021 but the transition from the "Merkel Era" might be less smooth than envisaged by her. The second half of the current legislative period could be bumpy as both coalition partners’ preferred option after the next regular federal election in 2021 seems to be to form a government with other parties and the desire for differentiation could make governing less easy. The Greens (together with liberal FDP) are unlikely to want to step in to fill the gap created by any SPD departure as polls suggest that the Greens could double their share of the vote in fresh Bundestag elections.
Note however that under the constitution a German chancellor remains in office until a new chancellor is elected and could also act with a minority government. However, a government that cannot command a parliamentary majority would add to the political risks at a time when global trade tensions, EU stresses (Brexit, Italy) and the impending replacement of important roles such as ECB president or chair of the EU commission require strong leadership in and from Europe’s biggest economy. Though neither SPD nor CDU/CSU seem prepared for new elections, the latest events could have unintended consequences.
Issue #4: France – reform ambitions scaled back
The victory of Marine Le Pen’s party in the European parliamentary election should interpreted with caution as the party failed to broaden its appeal. Its margin of victory was smaller than in the 2014 election and its share of the vote was only slightly higher than Le Pen’s first-round showing in the presidential election. Other rivals of President Macron also underperformed, meaning that he remains in the pole position for re-election in 2022. However, France’s reform agenda looks now less ambitious than previously expected. Macron has also had to abandon his medium-term objective of a balanced budget due to the yellow west protests. All this may not create short-term trouble but could add to long-term risks.
Issue #5: Spain – no government, no problem?
In Spain, a government still hasn’t been formed after the inconclusive April 2019 general election. Acting Prime Minister Pedro Sanchez has improved his position with his Socialist party winning the European elections. It seems that a coalition between the Socialists, the anti-austerity force Podemos and regional groups is within reach. With robust economic growth, there is little incentive for a new government to risk a clash with the EU over fiscal policy – particularly as the budget deficit will likely decline below 3% of GDP this year, which would allow Spain to exit its Excessive Deficit Procedure. A strengthened center-left government in Madrid could however change the dynamics in discussions over austerity and broader Eurozone reforms, although Spain’s robust economy is unlikely to be derailed by politics, even if coalition negotiations drag on. Spain has experienced persistent political uncertainty over recent years and the economy has still grown strongly.
Issue #6: Austria – the dangers of political fragmentation
The chancellorship of Sebastian Kurz in Austria has ended unexpectedly after the coalition of his ÖVP with FPÖ broke up, following the latter’s involvement in a scandal. Mr. Kurz, having ejected the FPÖ from the coalition and called new elections, had expected to run a minority government until these elections, but lost the subsequent vote of confidence. Instead, until the new elections (most likely in September) a technocratic government under the leadership of independent Brigitte Bierlein has been formed. The European election results could be seen as a sign of support for Kurz, as his ÖVP gained 7.6 percentage points to 34.6%. At least over the summer, this relatively small EU member is therefore in an unstable political situation and a good example that governing in a fragmented political landscape can prove more challenging than in the past.
Issue #7: Greece – more clarity ahead?
Greece – which can be seen as the trigger (if not the cause) of the European crisis which started back in late 2009 – has not been a market concern over the last few quarters. Greek 10-year government bond yields fell to an all-time low of under 2.9%. Although Greece’s public debt is still the highest in the Eurozone, as a percentage of GDP, it is on a downward trajectory and has been restructured under favorable terms. The share of government debt (in % of GDP) that has to be repaid over the next year is also much smaller than, for example, in Italy. Furthermore, opinion polls suggest that Kyriakos Mitsotakis’s New Democracy, which is seen as more pro-EU fiscal rules than the governing Syriza, could win the snap general election (due on July 7). New Democracy candidates appear to have done well in local elections this Sunday.
We maintain our call to take profits and recalibrate.
Our central scenario is that a solution to U.S./China trade differences will take time to appear, implying that markets are likely to remain volatile. European political worries could further unsettle markets.
As we have noted before, this could be a good time to realign your portfolio in quite a comprehensive way within agreed regional and sector preferences and with a focus on long-term themes.
In the current environment, it makes sense to be underweight on equities. European equities have seen continued outflows and it is difficult to see a short-term trigger that could make markets more positive here.
Fixed income in general (at a global level) could be more resilient than equities in coming months.
However, we would be wary of increasing a portfolio’s exposure to core government bonds.
Funds received from recalibrating equity allocations could instead be reallocated to some other forms of fixed income, long term investment themes or, temporarily, cash.
Within fixed income, the ECB keeping rates “lower for longer” is likely to be a major theme. As a result of this, the hunt for yield is likely to persist in the European bond space.
The hunt for yield should not however obscure investors to the risks surrounding some higher-yielding government bonds in the Eurozone periphery (most obviously, Italy). Be cautious here.
Some corporate high yield issuers could find it harder going in an environment of slower growth. But there are areas (e.g. European crossover credit) that could fare relatively well.
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