European Opportunity and Political Uncertainty

investment insights

European Opportunity and Political Uncertainty

Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

Stéphane Monier

Chief Investment Officer
Lombard Odier Private Bank

Europe’s macro-economic indicators point to growth and falling unemployment, but there are political problems to take into account. The eurozone will probably expand 2% in 2019 thanks to the region’s reasonably sound macro-economic fundamentals. The risks all relate to trade and the domestic politics of Italy’s budget and the UK’s Brexit negotiations.

Unemployment in the European Union is falling, and rising wages are supporting rising demand while the unemployment gap, the difference between an economy’s full employment rate and the number of jobless, continues to shrink (see chart). In fact, much of the slowdown reported in Europe’s economy this year is about short-term trade disruption and transitory factors that will have disappeared before next year, or sooner.
 

Much of the slowdown reported in Europe’s economy this year is about short-term trade disruption and transitory factors that will have disappeared before next year, or sooner.


A good example was the recent third-quarter data for the eurozone’s gross domestic product. While most of the region’s economies posted expansions in line with expectations, the number halved to a barely-there 0.2%. Two economies, Italy and Germany, account for the miss. Italy’s budget discussions with the European Commission are widely discussed. Less obvious, for now, is the impact of new emissions testing procedures on the German car industry, which accounts for around 10% of the country’s goods exports by value. The new tests had a short-term, though only temporary, impact on production. Indeed, the rebound in the car industry may come as soon as the last quarter of this year.

We anticipate two rate rises from the European Central Bank to bring interest rates to zero, and the market has already factored-in an increase in September or October next year, followed by another in December 2019. The eurozone’s expanding economy will therefore give the ECB the space it needs to slowly raise rates after it brings quantitative easing to an end this year. Don’t forget that the US Federal Reserve started raising rates once in 2015 and once again in 2016. There is no reason that the ECB won’t take its time too.

Recent history has taught investors to be fearful of current account deficits. Yet current account balances across the eurozone, including Italy, have improved since the financial crisis. Thanks to economic restructuring the current accounts of the eurozone nations are nothing like the near-bankruptcy of Greece, Portugal and Spain on the eve of, and during, the financial recession and sovereign crisis (see chart). In fact, the members of the common currency now boast a current account surplus of 3.6%.

The UK, Brexit aside for a moment, is in a rather different position. Its current account deficit has moved little since before the financial crisis (from 4.9% to 3.5% of GDP) and is worse than all its European neighbours as well as being in absolute terms, more than three times higher than France, its nearest EU competitor.


Populist Politics

Let’s turn now to the political uncertainties facing Europe. The financial fall-out of the past decade has bequeathed something even harder to rebalance than struggling economies: the tendency for voters to look for more extreme solutions from their political leaders. There have been signs of this shift, usually to the political right though not always bringing populists to power, in most EU member states, including Germany, Hungary, Austria, the Czech Republic, Poland and France. Still, the most pressing questions surround Italy and the UK.
 

The financial fall-out of the past decade has bequeathed something even harder to rebalance than struggling economies: the tendency for voters to look for more extreme solutions from their political leaders.


In addition, the European Union as a global political entity appears to be lacking leadership. German Chancellor Angela Merkel is in the process of stepping aside (see our recent article) and President Emmanuel Macron of France is weakened in opinion polls and missing support for the vision that he has articulated for a more federal bloc.

Italy’s coalition of anti-establishment and right-wing parties came to office this year promising to limit immigration and borrow more to fund a universal income and repeal pension reforms, rather than lower public debt (see our recent article on Italy). That looked to be setting up a showdown with the European Commission, as the EU’s fiscal rules say that members of the Eurozone have to keep their deficit-to-GDP ratio under 3%, and public debt to less than 60% of GDP.

So far, the showdown is only smouldering. The coalition has promised its electorate that it will stick with its spending plans. The European Commission has asked Italy’s government to make adjustments, fearing that the plan will only add to the country’s debt repayment burden. Italy’s budget targets promise to keep budget deficit under 2.4% next year, and says that its debt would fall over three years to 126% of GDP in 2021. In September, rating agency Fitch left Italy’s rating unchanged at ‘BBB’ but cut its outlook on Italian debt from ‘stable’ to ‘negative’ citing concerns about the coalition’s increased spending plans.

The messages from Italy are sometimes contradictory, but in the meantime, the government’s proposals are playing well with Italy’s electorate, and the coalition is aware that the European Commission only has a few months until European Parliamentary elections next May.

“If Europe likes it, we’ll be happy, but if not we’ll plough on regardless,” deputy Prime Minister Matteo Salvini said this week.

Any threat that the European Commission may decide to seek penalties on Italy looks unlikely. While the Commission could threaten fines of as much as 0.5% of a country’s GDP, in this case around 9 billion euros, the so-called excessive deficit procedure (EDP) was only applied against Spain and Portugal, and in both cases, the eventual fine was zero.

Brexit uncertainties

The new Italian coalition government has at least been clear that it has no intention trying to leave the European Union. In contrast, at the time of writing, the political uncertainties surrounding the UK are high. The UK and EU have agreed a draft withdrawal agreement from the bloc that, while in line with expectations, now needs the approval of the other 27 European member states and will eventually be subject to a vote in the UK Parliament (see calendar).

Theresa May’s government has survived the initial unveiling of the agreement with the resignations of four cabinet ministers. However, there are challenges ahead to the Prime Minister’s leadership from within her own political party, as well as from a parliament largely hostile to the draft. The process of negotiation and compromise has left the UK with a potential deal that no side voted for at the 2016 referendum and is being widely criticised.

Our central scenario at this stage is that the agreement eventually gets through parliament, in time for it to become law and avoid a ‘no deal’ exit on 29 March next year. The probabilities for alternative scenarios, ranging from failure in the UK parliament and renegotiations with a different government in place, to a no-deal Brexit, are still possibilities. Finally, we cannot yet rule out that the UK remains within the EU, or agrees to a very ‘soft’ form of Brexit after elections and/or a second referendum. All told, the weeks ahead will inevitably be volatile for UK assets and sterling.
 

Investment implications

Broadly speaking, the recent market turmoil has created short-term opportunities for investors and while the economic fundamentals remain sound, we favour remaining invested in equities while selling more illiquid assets such as emerging debt in local and hard currency, corporate credit, high-yield credit and convertible bonds.

We have recently increased our exposure to eurozone government bonds based on the market’s overly conservative pricing of Italian political risk and our assessment is that there is no solvency risk for Italy.

There are good reasons for looking at owning Italian debt right now. With a 3% current account surplus, Italy is not in any danger of missing its debt payments since, even after interest payments the Italian balance of payments is in surplus. While the rating agencies have cut their outlook, 10-year government debt is trading at 3.46%. This means that a lot of the risk is already priced-in (with yields closer to those of some emerging economies than other developed economies) while investors can also benefit from a steeper yield curve on Italian debt. For a USD-based investor, it also makes sense since the interest rate differential makes currency hedging attractive.

Important information

This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.

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