Where do we stand?
Posted by Serrai Invest Capital Ltd ( Media Team)
Instead, political risk has so far proved to be all bark and no bite, with voters in both the Netherlands and France rejecting populist anti-euro candidates, and the risk in Germany appearing negligible. The areas of uncertainty are Italy, where popular support for the euro is much lower than elsewhere in Europe, and the UK, where the Brexit outlook remains clouded despite the likelihood of an increased Conservative majority in the upcoming general election.
Germany – federal election in September – risk to Euro extremely low
After a strong showing in the polls for the rival Social Democrats (SPD) at the start of the year, the pendulum has swung back, with Angela Merkel’s Christian Democrats (CDU) the most likely to lead a coalition government following September’s election.
Importantly, all parties are ruling out a coalition with the right-wing populist party Alternative for Germany (AfD). In all three of the recent state elections, the eurosceptic and anti-immigration AfD managed to jump over the 5% popular vote threshold to enter into the local parliaments for the first time, but the gains were much smaller than expected. The declining refugee crisis and the strong state of the economy appear to have weakened the appetite for radical change among German voters.
Recent developments should offer some reassurance to investors that populism in Europe is losing momentum and a political black swan event out of Germany is now a very low probability.
Italy – election by May 2018 – risk of Euro exit: Non-negligible but not the most likely outcome
Italy is the only large country in the eurozone where popular support for membership in the single currency is below 50%. Only one of the country’s four leading political parties is an active supporter of Italy remaining in the eurozone. And the anti-establishment Movimento 5 Stella (M5S) is pushing for early elections to take advantage of a slight lead in the polls over the centre-left Partito Democratico (PD).
However, early elections still appear unlikely, particularly given lack of progress on the approval of a new, single electoral law for the two chambers of Parliament. When elections do occur, it is not the most likely outcome that M5S would win an outright victory. It is also unlikely that M5S would be able to form a coalition government, given the ideological obstacles it would face forming a coalition with either Lega Nord or Forza Italia, the other parties that are either tepid or hostile towards the euro.
May shows little sign of softening her insistence that the UK will leave the single market and the EU Customs Union.
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, it should also make it much harder for any single party to take the country out of the eurozone.
The Italian equity market has been one of the eurozone’s best performing markets this year, second only to Spain. Investors appear, probably correctly, to place a relatively low probability on Italy calling a referendum on leaving the euro.
UK – election on 8 June – larger Conservative majority wouldn’t remove Brexit uncertainty
Current forecasts suggest the Conservatives will win a large victory in the unexpected general election on 8 June, with a much larger majority in parliament than they currently hold. However, the outlook for the Brexit negotiations will remain highly uncertain, because the prime minister has herself ruled out “softer” forms of Brexit, in the Conservative manifesto.
May shows little sign of softening her insistence that the UK will leave the single market and the EU Customs Union. She has also flatly ruled out the possibility of the European Court of Justice having any role in UK laws and regulations after Brexit. It therefore seems likely that the UK will end up with significantly less access to EU markets after Brexit, especially in services.
We expect sterling to remain volatile. Signs that the UK could get a reasonable deal should support the pound, whereas fears that the UK will get a bad deal, or no deal, would likely lead to further sterling weakness.
So, while the outcome of the election appears predictable, the outlook for sterling and for the relative performance of large, internationally focused companies relative to smaller domestic focused companies is likely to remain highly uncertain for several years.
Political risk in Europe has diminished significantly with the victory of pro-euro leaders in the Netherlands and France. While markets have already reacted positively, more than half of the money that came out of European equities since January 2016 has yet to return. The overall picture is one of an improving European economy, with earnings growing very strongly and investors still relatively cautious. In this environment, we believe the outlook for eurozone equities is positive.
However, in the UK, uncertainty remains high. Though UK equities overall could make gains, large market cap or sector bets could prove costly.