This time last year, political risks hanging over Europe worried investors; Geert Wilders in the Netherlands and Marine Le Pen in France threatened an anti-globalisation uprising, while Britain reeled from the Brexit vote.
Thankfully, Mark Rutte and Emmanuel Macron saw off their respective threats, and Brexit negotiations seem to have - finally - taken a turn for the better, but that does not mean that Europe is free from political uncertainty.
The UK’s vote to leave the EU and Donald Trump’s election as President of the United States led to predictions of populism spreading into continental Europe in 2017.
Keith Wade, chief economist at Schroders, says the election of Macron as President of France was “a turning point”, as other elections passed with market-friendly results. “Macron’s victory was a signal that Europe was not going to go the same way as the UK and that, actually, it was moving more in a pro-EU direction.”
Francesco Conte, manager of the JPMorgan European Smaller Companies Investment Trust (JESC), says the stars are aligning for Europe in what is now the most benign political environment he’s ever seen. That’s been reflected in strengthening economic growth numbers across the board.
Many are now constructive on Europe. Funds in the Investment Association Europe ex-UK sector have seen nine consecutive months of net inflows, according to Morningstar data, reversing a 12-month period of net outflows between February 2016 and January 2017.
But recent developments in Spain, Italy and Germany suggest the region is not quite out of the woods yet.
The collapse of coalition talks in Germany is the political surprise of the year and James Bateman, chief investment officer of multi-asset at Fidelity, says the situation presents “by far the biggest systemic risk in Europe”.
German Elections
As the EU’s largest economy, Germany has a big say on decisions affecting the bloc. Bateman now sees Merkel taking “a tougher stance in a lot of areas” as she balances a need for doing what she believes is right with a need to keep her party, the Christian Democrats (CDU), electable.
That could mean “a bit less pragmatism and a bit more playing to the masses”. And it may spell bad news should a peripheral country descend into crisis and have to leave the EU. “Germany is going to be far less accommodative than it has been in the past,” adds Bateman.
Opinion is split on whether there’ll be another election. Analysts in UBS’s wealth management division give it a 35% chance; Mark Burgess, chief investment officer at Columbia Threadneedle, thinks it’s more likely.
UBS give another grand coalition between the CDU and Social Democrats (SDP), its base case, a 50% chance. But negotiations are likely to run well into 2018, with the SDP demanding a high price.
Conte says fears of populist parties winning elections in Europe are overplayed and recent polls in Germany suggest it would get a similar result to the previous vote. “Following World War II, European constitutions were all designed to avoid extreme leaders coming into power,” Conte explains.
“You get coalition governments in all European countries apart from France – and that’s by design.” France has a system that tends to favour centrist parties anyway.
Brexit
Speaking last week, Wade said Germany’s wrangling could set Brexit talks back, with negotiations likely to be put back from December to March should Merkel need to fight yet another election.
But the news overnight that the UK has offered up to €50 billion to the EU to settle its “divorce bill” has assuaged some of Burgess’ fears, saying this morning: “The outlook for the UK economy is better than it was”.
In contrast, Joshua Mahony, market analyst at trading platform IG Group, doesn’t think things are going to go as swimmingly as people now assume.
“The EU have stood firm and are trying to draw this down to the line and the closer it comes to the line the worse deal we get for the UK.” As a result, he sees further sterling deterioration in the year ahead – good news for the FTSE 100.
Spain And Italy
Elsewhere, Burgess thinks that Catalonian independence could be a bigger threat to Europe than Brexit: “There is also the election in Italy to consider.”
Wade is worried about Italy and says that, while eurozone economies continue to recover, saying, “it’s still quite a mixed picture. Although Europe is growing as a whole, Italy is lagging behind a long way. It hasn’t got back to where it was before the global financial crisis.”
That said, Burgess insists the political risks ahead are not sufficient to derail economic growth or the stock market, with inflation posing a bigger risk.
“It’s remarkable how strong markets are and how they take everything in their strides, from nuclear tests to elections and everything in between,” adds Chris Beauchamp, chief market strategist at IG.
Mahony adds: “There’s been so many major hurdles this year… one way or another they all seem to get resolved. Yes, there will be bumps along the way, but I don’t necessarily think there’s going to be anything that’s going to hurt the overall picture.”
Despite that, Nick Peters, multi asset portfolio manager at Fidelity, notes that there’s been a divergence in performance of the main markets in both Spain and Italy. While the Spanish Ibex 35 has fallen 7.5% since hitting a two-year high in May, Italy’s FTSE MIB has stayed steady.
“There are cases where the market doesn’t ignore political events, the Spanish market being a great example,” he explains.
“We think markets overreacted and the Spanish market will bounce back; we’ve got Italian elections coming up and there’s huge uncertainty about the outcome of that which the market has ignored.”
Many think Europe’s still the place to be, with Man GLG Continental European Growth, Schroder European Alpha Income, IP European Equity and FP CRUX European Special Situations all seeing over £300 million of net inflows year-to-date.
But Beauchamp says that means Europe is now a crowded trade. He sees the UK and US as holding the best opportunities.
