EUROZONE BREAKUP REMAINS A RISK
‘Complacency’ is a worry as populist threat lingers, Jonathan Ratner explains.
Emmanuel Macron’s victory in the French presidential election came as a relief for global financial markets, since it knocked off one big political risk that had investors very concerned at the start of 2017.
There was fear that the antiestablishment wave that successfully led to the election of Donald Trump in the U.S. and the Brexit win in the U.K. was spreading across Europe.
But Macron’s wide margin of victory appears to give him a strong enough mandate to push forward with a pro-European Union and reform agenda and, for the time being, effectively put an end to doubts about the future of the euro and the trading bloc.
Although Macron’s victory failed to provide a big lift for global stocks, as it was largely baked into market expectations, it further cemented the current popularity of risk assets among investors.
That belief is evident in the S&P 500 and Nasdaq hitting record highs this week, and other markets around the globe experiencing equal, if not better, performance this year.
It also shows up in the CBOE Volatility Index, otherwise known as the VIX, which fell below 10 this week — its lowest level in more than a decade.
But the sanguine approach investors continue to adopt when it comes to market risk — such as high valuations or political uncertainty — is a worrying trend.
“The successful navigation around the latest in political risk appears to have prompted a significant degree of complacency with respect to hedging potential downside moves,” said Michael Hewson, chief market analyst at CMC Markets U.K.
For one thing, the EU is clearly not out of the woods yet despite plenty of pro-European sentiment and recent economic improvements.
The European banking system remains extremely fragile. It still holds one-trillion-euros worth of toxic loans dating back to the start of the eurozone crisis in 2009, and loans in or near default in Southern Europe continue to be a big problem.
The job market isn’t exactly rosy either, even though eurozone GDP rose by an annualized rate of two per cent in the first quarter of 2017, more than double the U.S. growth rate during the same period. That’s particularly true for youth unemployment levels, which stand at roughly 40 per cent in Spain, 35 per cent in Italy and 25 per cent in France.
“Elevated unemployment, together with rising income inequality, will likely continue to fuel the embers of populism in France and abroad,” said Fotios Raptis, senior economist at TD Bank.
On the political front, Germany’s federal election doesn’t look like it should be a significant issue for markets, but Italy is quickly becoming a concern as the euro-skeptic Five Star Movement gains popularity. An election there is due within a year or so, and might even be held before the end of 2017.
Italy has benefited from EU membership, but domestic growth is slow and per-capita income has failed to rise.
Shaun Osborne, chief FX strategist at Scotiabank, noted Italy is losing ground to larger eurozone economies, and that’s being reflected in polling numbers that show declining support for the euro and an increase in anti-euro sentiment.
“More importantly, perhaps, the survey shows more Italian respondents feel they would be better off outside the eurozone than those feeling they are better off inside for the first time,” Osborne said. “We don’t think the eurozone is entirely clear of political risks or structural challenges.”
On the positive side, just as Trump’s pro-growth acceptance speech in November gave markets a confidence boost, Macron’s decision to enter his victory party to Europe’s anthem, “Ode to Joy” instead of France’s “La Marseillaise” may have been the most important event — and biggest surprise — of the French election.
“This would be equivalent to Donald Trump being introduced at his victory party to the ode of NAFTA,” said Krishna Memani, chief investment officer at OppenheimerFunds.
“This was a big statement from Macron about his commitment to Europe and sets the tone for his presidency.”
But as Trump quickly learned after he took office, keeping promises isn’t easy and the European Union is a far more complex entity than the U.S. and much of the population remains unhappy despite improving growth in the region.
The populist wave is not going disappear in Europe, and that should keep the threat of a eurozone breakup at the front of investors’ minds.
“We don’t think we can say ‘adieu’ to political risk in the eurozone at this point,” Osborne said. “It’s more a case of ‘a più tardi’ — see you later, or later in the year to be a little more precise.”