Investors entered 2017 full of distrust when it came to Europe. After years of the region’s underperformance relative to the US, they were not about to gamble yet again on this endlessly disappointing market – particularly when there was so much political uncertainty coming down the track. With populist parties doing well and major elections looming on the horizon in the Netherlands, France and Germany, the fear was that it might be Europe’s turn to suffer a populist shock, putting the very existence of the eurozone in doubt.
What a difference a few months can make. Voters in both the Netherlands and France have followed the Austrians in rejecting populist anti-euro candidates, and the risk of a success for extremist parties in Germany in September is negligible.
Italy still looms on the horizon as a key source of risk, and prospects for the UK are even more uncertain following the recent election. But the victory of Emmanuel Macron in the French presidential election in May offers the possibility of a stronger Franco-German relationship. With that comes the prospect that political change in Europe might actually do some good for a change. At the very least, it clears the air for investors to focus more clearly on the eurozone’s improving fundamentals.
EUROPEAN CORPORATE EARNINGS ON THE UP
The big stories are still the economy and European corporate earnings, both of which are gaining pace, having outstripped the US in the first three months of 2017. But, given that political risk and Europe have been twinned in people’s minds for so many years, it’s worth asking what’s gone right for European politics since January – and what the implications could be for investors.
The French have historically voted to give an absolute majority at the National Assembly to the party of their recently elected president, and Macron’s newly created party has been riding high in the polls, and the new president has reached out to people from both sides of the political spectrum to form his cabinet. Macron’s success in winning a clear majority should be positive for France and for investors in the medium term.
GERMAN ECONOMY LOOKS SECURE
Looking at the current data, Germany’s economy is in a comfortable position. At 3.9 per cent, the unemployment rate is at a record low, the budget is in balance and net exports are at a record high. Earlier in the year, it looked as though the new Social Democrat (SPD) leader, Martin Schulz, might be poised to take the traditional left of centre party to victory in the election in September. However, recent state elections have not gone his way, and the betting is now on chancellor Merkel to remain chancellor after the election, quite possibly under a similar coalition arrangement.
Some European policymakers were hoping an SPD victory might produce somewhat more expansionary fiscal policy in Germany, and perhaps a more proactive approach to reforming the eurozone. But waning support for the extreme-right Alternative for Deutschland party in the polls does offer reassurance to investors that populism is not gaining a foothold in Europe’s most important economy.
Italy remains a key area of political concern for Europe, and rightly so. It is the only large country in the eurozone where popular support for membership of the single currency is below 50 per cent. Early elections cannot be ruled out, and the reality is that only one of the country’s four leading political parties is an active supporter of Italy’s membership in the eurozone.
This is a worrying prospect indeed, in a major European economy with one of the world’s largest government debt mountains. But early elections in Italy appear unlikely as we move into summer, particularly given lack of progress on the approval of a new, single electoral law for the two chambers of parliament.
There must be an election in Italy by May 2018, but its current standing in the polls would not give the anti-European Five Star Movement the 40 per cent necessary to govern alone. It could form an anti-European coalition with Lega Nord or Forza Italia, but in practice this is considered very unlikely, given the gaping ideological and other differences between them.
For better or worse, the next election in Italy is likely to increase the fragmentation of Italian politics. This is not helpful from an investment standpoint, since it would make important reforms more difficult and continued political uncertainty more likely. However, this should also make it much harder for any single party to take the country out of the eurozone.
ITALIAN AND GERMAN BOND SPREADS NARROW
Spreads between 10-year Italian bonds and German bunds remain higher than between German and Spanish ones, but they have fallen since the French presidential elections, while the Italian equity market has been one of the eurozone’s best-performing markets this year, second only to Spain. Rightly or wrongly, markets seem to be placing a relatively low probability on Italy calling a referendum on leaving the euro.
As ever, the UK is a special case. The failure of the Conservatives to gain an absolute majority in the recent snap election was not the result that financial markets – or prime minister Theresa May – were expecting. Instead of the larger Conservative majority the party was hoping for, the government will be forced to rely on the support of Northern Ireland’s Democratic Unionist Party to remain in office. All this, of course, takes place with formal negotiations over Britain’s exit from the EU just about to start.
The election outcome was bad news for the Conservative party, but the implications of the result for investors are not so clear-cut. Investors do not like uncertainty – but nor did they favour the prospect of a hard Brexit, with the UK out of the single market and out of the EU customs union, which May had promised. There may not be a parliamentary majority willing to support this vision of Brexit any more. We don’t know what will happen, but the chance of a less economically damaging exit from the EU – even a second EU referendum – are higher than they were before.
These considerations may help to explain why the pound and other UK markets did not react dramatically to the election result. The political mood may have changed fundamentally; but the short-term fundamentals driving the economy – the strength of the UK consumer and the global recovery – are much the same.
We do not expect sterling to recover its losses since last year’s EU referendum any time soon. However, we do expect a fair bit ofcurrency volatility in response to news about the stability of the government and its approach towards the negotiations in Brussels. So the relative performance of large-cap, internationally focused companies relative to mid- and small-cap domestic focused companies is likely to remain highly uncertain for several years. In this environment, UK equities could still perform well, but it probably makes sense to avoid taking large sector or size bets.
Across the continent, all the good political and economic news has helped push up eurozone equities in recent months, with the total return on the main MSCI EMU (eurozone) index outperforming the US market (S&P 500) in both dollar terms and domestic currency since the start of 2017, for the first time in many years. But this has not brought a flood of money. In fact, around half of the equity flows which came out of European equities over the course of 2016 have yet to return.
European political risk has not disappeared. Far from it. The biggest risk on a 12-month timeframe is that the Five Star Movement in Italy will either win the election outright or manage to form an unlikely coalition with other anti-European forces. If that prospect does not materialise, there is still a decent possibility that the next recession will reignite fears over the sustainability of Europe’s public and private debt.
Nothing is ever certain when it comes to European politics, and the long-term problems with which president Macron and others must now grapple are immense. But right now the sun is shining on Europe’s economy, and politics might even be in a position to help. We may look back and say the greatest risk facing investors in Europe in 2017 was the risk of grasping the opportunity too late.
Stephanie Flanders is chief market strategist for Europe at JPMorgan Asset Management